German equities have been propelled higher by strong first-quarter earnings from such industrial powerhouses as Siemens AG, Bayerische Motoren Werke AG and Mercedes-Benz Group AG. But with manufacturing orders starting to weaken, there are question marks over the sustainability of those profits. “These problems we have in Germany are accumulating,” BASF SE Chief Executive Officer Martin Brudermueller told Bloomberg News last month. The International Monetary Fund estimates Germany will be the worst-performing economy among the Group of Seven nations this year. If it stumbles further, it may drag the entire euro zone into recession.

One concern is that China’s reopening from pandemic lockdowns has been patchy as it focuses on its own self-sufficiency, with limited benefits for European exporters. Italy’s precision manufacturing sector, as well as its luxury brands, are exposed. The French CAC 40 index made a new high in April, led by luxury giant LVMH Moet Hennessy Louis Vuitton SE. But a slump in the bling sector on faltering demand in the US and China has seen a 10% correction for the high-end retailer.Bank of America Corp. strategists are anticipating a 20% slump in European stocks this year, predicated on a hard recession call.  They reckon the drag from credit tightening will  weaken economic momentum across the bloc, reducing corporate earnings. Deutsche Bank AG strategists also expect European earnings to slump in the second half. Their estimate is for German GDP to decline by 0.3% this year, in line with the IMF’s call, and for a limpid recovery of only 0.5% in 2024 — with forecast risks skewed to the downside. Goldman Sachs Group Inc. strategist Guillaume Jaisson reckons that the “markets might be ignoring recession risks.” Moreover, European equity indexes don’t have much in the way of tech stocks likely to benefit from the hype over AI that’s fueling outsized gains for some US firms, notably chipmaker Nvidia Corp.

Germany has long depended on cheap Russian energy to power its world-renowned manufacturing base — and has been equally reliant on China to buy its prodigious exports. That low-cost input to high-value output model has been shattered. Total German auto production fell to just 3.3 million vehicles at the end of 2022 from nearly double this level six years ago. German energy costs are significantly higher than the rest of the G7, as it relied so much on imports of oil, coal and gas from Russia. Many other EU countries are similarly vulnerable to increased industry power bills. 

Germany’s three-party coalition is straining over a shrinking federal budget for the first time in many years, struggling to finance a huge energy transition just as higher energy prices and lower investment crimp growth. Germany’s annual debt costs have risen tenfold to more than €40 billion from under €4 billion in 2021, courtesy of higher ECB interest rates. But due to its long-term fiscal restraint Germany can at least splurge  if it needs to; with a debt-to-GDP ratio of 60%, it has plenty of headroom.

The same cannot be said of much of the rest of the euro area. Italy, with a debt-to-GDP ratio of around 145% and the world’s fourth-largest debt load, is much more vulnerable to higher financing costs. While the nation stands to receive close to €200 billion ($214 billion) in grants and loans from the EU pandemic recovery fund, it has to complete a stringent list of requirements, including budgetary reform and verification milestones, to do so. The FTSE MIB Italian equity index, up 12.5% this year, reached its highest in more than a decade in January. Economic growth has been minimal for the EU’s third-largest economy this century, and its banking sector has been a millstone. Corporates cannot expand their businesses without steady and plentiful access to credit; unfortunately, loan demand is slumping across the euro area as higher borrowing costs start to bite.

The wider problem is the credit tightening that Bank of America warns about. Four worrying signs point to a credit crunch heading Italy’s way. First, Italian customer deposits have shrunk by €80 billion over the past year, restricting banks’ ability to lend. Second, the Italian central bank’s own cash balance has run down to a historic low of €15 billion from €75 billion in July. Third, the ECB is no longer reinvesting the maturing holdings from its €2.6 trillion Asset Purchase Program, which previously helped cap Italian yields. 

Finally, the ECB’s once super-generous bank-lending program, Targeted Longer-Term Refinancing Operations, is expiring. Italian banks were the foremost beneficiaries of this credit facility, with nearly half of the country’s banks relying on the ECB for financing. Italian banks have already had to repay €112 billion, with another €143 billion due by June 23. The remaining €180 billion must be repaid over the next year. Replacing nearly half a trillion euros of liquidity in relatively short order is going to be a challenge for the entire region.

With the German growth engine stalling, the rest of the euro zone looks increasingly vulnerable. Unless and until Germany stops sneezing, European equities risk catching cold.

More From Bloomberg Opinion:

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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