Engine trouble: VW's struggles reflect Germany’s economic woes

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The challenges facing the German economy are well-documented, with growth remaining sluggish and Purchasing Managers' Indexes (PMIs) - a reliable indicator of future economic activity - continuing to point to ongoing struggles in the manufacturing sector. Recent headlines around Volkswagen (VW), Germany’s largest company and the second-largest in Europe (both ranked by revenue), behind the oil and gas giant Shell, put some perspective on the economic difficulties facing the German manufacturing sector.

Globally, manufacturing has faced a significant slowdown due to rising energy prices, higher raw material costs, and tighter monetary policy from central banks. While peripheral European economies like Spain, Greece, and Portugal have shown surprisingly strong growth, core countries such as Germany, France, and the UK have struggled. Germany, in particular, has been the weakest economy in core Europe, heavily reliant on manufacturing without the same robust service sector other nations have to offset the downturn. 

Historically, the German manufacturing sector, centred on autos, industrials, and chemicals, has been a key growth engine for Europe. These industries and their profitability has been built around cheap Russian gas - a supply unlikely to resume soon. Additionally, labour and raw material costs have surged as inflation skyrocketed post-Covid. These dynamics have pressured the entire manufacturing sector, particularly autos. VW alone contributes almost 8% to German GDP, with BMW and Mercedes each contributing around 3.5%, highlighting their critical economic importance to the German economy. 

VW is undeniably under the most strain and has been driven to take drastic measures.

The company recently announced plans to close three factories in Germany, reduce operations at all other sites, and implement a 10% wage cut affecting 140,000 workers. These steps, though drastic, are a reflection of the severe challenges the company faces, as highlighted in their latest financial results.

"Volkswagen Brand reported an operating margin of only two percent after nine months. This highlights the urgent need for significant cost reductions and efficiency gains," says VW’s CFO and COO, Arno Antlitz.

This follows VW’s second profit warning in three months, highlighting the urgent need for significant cost reductions and efficiency gains to restore profitability. These measures would represent VW’s first factory closures in Germany in its 87-year history.

However, these cuts are not guaranteed to proceed smoothly. The powerful unions in Germany are expected to strongly oppose the closures, potentially leading to strikes and further disruptions to both VW and the broader German economy.

Several factors contribute to the current struggles of the German auto industry:

  • Competition from Chinese automakers: Chinese car manufacturers are becoming increasingly competitive, offering high-quality vehicles at reasonable prices both in Europe and their domestic market. The advent of battery technology has levelled the playing field, leading to the emergence of credible alternatives like Tesla and numerous Chinese brands, all seeking to capture market share from traditional automakers.
  • Weak consumer demand: Economic uncertainty and tight monetary policy has led consumers to shy away from high-value purchases. 
  • Rising costs: Higher energy, material, and labour costs have squeezed margins. Germany’s dependence on cheap Russian gas has particularly impacted the auto sector, leading to higher production costs in the face of weak demand, especially from China.

These issues are not unique to VW. Other German automakers, including BMW, Mercedes, and Stellantis, have also issued profit warnings, reflecting similar struggles. In contrast, US automakers have shown more resilience, with the US consumer on a stronger footing and having less reliance on Chinese demand.  

The broader implications of these industry struggles are significant. Major job cuts in the auto sector could further weaken the German economy, and the drastic action from VW management highlights the scale of the challenge facing the sector. 

VW’s current struggles are a microcosm of the broader issues facing the German economy. While the auto industry’s challenges are significant, they underscore deeper structural problems that will require substantial time and effort to address. German economic forecasts continue to point to growth remaining below potential which emphasises the need for Germany to reestablish its competitive edge on the world stage.

Despite these challenges, there are some positive signs, with European growth exceeding expectations and inflation indicating consumer resilience, as we noted in our blog last week. For fixed income investors, the difficulties facing Germany’s manufacturing sector are largely reflected in current credit spreads, yet they highlight the need for further European Central Bank (ECB) rate cuts to support the struggling economy. While immediate credit concerns remain manageable, the evolving dynamics in the auto industry and broader manufacturing landscape emphasise the importance of active management to navigate potential volatility and capitalise on emerging opportunities.

 

 

 


 
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