• The slowing global industry has so far done little damage to the German recovery. In fact, during the second half of this year we have witnessed the largest decoupling between German and US business confidence in German favour since following the re-unification.
  • Consistent with this decoupling our GDP model points to continued strong growth in Germany in Q3. While the impetus from exports has slowed substantially during this autumn, the domestic investment recovery has gained further pace thus off setting most of the negative impulses from exports.
  • Looking forward, we still expect slowing in the German and Euroland economy during H1 next year, before re-accelerating through H2-2007. However, in the remainder of the year, key figures from Germany could continue to surprise on the upside, as the German VAT hike gives a yearend boost.
  • The ECB is likely to give some kind of hint with regard to policy in 2007 at the December meeting. At that time the information available will be mostly hike-friendly. Activity will seem robust, inflation expectations will not fall clearly below 2%, credit growth will continue to be strong, and most ECB members will still feel they have some more “normalising” of rates to do. Thus we push forward our expectations to the next rate hike from H2 next year to Q1 next year, and we continue to expect two rate hikes in 2007.

Investment recovery strengthening

Negative export impulses absorbed

The slowing of global industry has so far not damaged Euroland industry in any significant way.

While the momentum in exports has slowed significantly throughout 2006, the overall manufacturing sector in Euroland has proved more robust. Exports is usually the main driver of the momentum in the overall manufacturing sector in Euroland, but not this time.

In the chart below the tight correlation between exports growth and the manufacturing sector is obvious. While the strong manufacturing sector in Euroland may be due to lagged effects from strong exports in 2005, there is also another explanation.

The domestic recovery in Euroland, and in particular, Germany, has been cooking for some time, and it now seems to off set much of the weakness observed in global industry. In the chart below this is evident when looking at domestic capital orders in Germany, which is growing at its strongest pace since following the re-unification.

While we since last summer have been optimistic on the chances that the domestic economy could finally get started in Germany, we have been surprised to see the kind of dynamics witnessed during this summer and autumn.

Thus, in spite of slowing exports momentum, the domestic investment recovery in Germany has kept the overall industry on fire this autumn. In the chart below we have estimated Euroland industrial production on exports and German domestic capital orders. These two variables describe most of the dynamics in total industrial production. From the contributions, also shown in the chart, it is clear to see that domestic capital orders are contributing strongly to industrial production at the moment.

This means that Euroland will post decent GDP growth in Q3. And in Germany the economy will even maintain the strong speed from H1-2006. We expect GDP growth in Germany in Q3 of around 0.7%q/q. The investment recovery in German is simply making Euroland more robust.

This situation looks a lot like 1998, where Euroland industrial production kept up momentum in spite of global slowing. At the time we also saw a couple of excellent quarters from the domestic investment recovery in Germany, before it stagnated late 1998.

In all circumstances, the activity in Euroland continues to grow decently. Given the likely VAT impulse to ifo current conditions over the next couple of months, the impression of a continued recovery will prevail.

Looking into 2007

When looking into 2007 we still see downward risks in H1-2007. The global industry is still on a downward trend, although probably at a lower pace than over the past 3-6 months. In addition, the lagged effects from the euro strengthening early this year will be feeding through making Euroland manufacturing lose some of its momentum compared to global manufacturing, see chart below.

Unless domestic capital orders continue to explode we will thus see some slowing of manufacturing in Euroland during H1 2006. However, we remain of the view that global and Euroland industry will reaccelerate during H2-2007, see also our research paper: “Business confidence heading down” from 31. May 2006.

Implications for ECB

The more robust growth picture indicates that the ECB will not pause in hiking rates during 2007. In stead of hiking twice in H2-2007 as we have originally expected, we now expect a rate hike in March next year. Whether the ECB will hike rates again in Q2 remains an open question to us, but we still believe the ECB will end its hiking campaign at 4.0% by end 2007.