Economic outlook: What does the future hold for Germany?

The recessionary phase that began in late 2022 will be overcome only gradually. The most recent data has been largely deteriorating and leading indicators like the Ifo Business Climate Index and the Composite Purchasing Managers’ Index (PMI) are only hesitantly rebounding.

The manufacturing PMI stood at 43.1 in December, which while up from July-August lows near 39, still reflects a steeper rate of contraction.

While the European Central Bank has refrained from additional monetary tightening following September’s 25-basis-point policy rate hike to 4.50%, a shift to monetary easing appears unlikely before the second quarter of 2024.

Office construction will continue to face headwinds in 2024 (Photo: AdobeStock)

Market uncertainty

German construction activity remained in decline as 2023 ended, facing market uncertainty and high interest rates, according to the latest HCOB PMI survey, compiled by S&P Global.

Building companies were still firmly in retrenchment mode, registering further reductions in both employment and purchasing activity.

The survey also indicated a bleak 2024 outlook, with business expectations remaining historically low.

The HCOB Germany Construction PMI Total Activity Index – a seasonally adjusted index tracking changes in total industry activity – registered 37.0 in December, up slightly from November’s 36.2. Yet, this was still the second lowest in a little over three-and-a-half years and indicative of a steep rate of contraction.

As was the case throughout almost all of 2023, housing activity was the main drag on the construction sector. While the rate of contraction eased slightly, it was still one of the quickest on record.

By contrast, declines in both commercial and civil engineering activity gathered pace, reaching the fastest for 34 and 11 months, respectively.

Reports from surveyed businesses indicated greater caution among customers amid a backdrop of economic and political uncertainty and high interest rates.

The rate of decline in new orders eased only slightly since November, meaning it was still among the quickest in the series’ history going back to 1999.

Year-ahead expectations were broadly unchanged from the month before and historically low, with over half of businesses (56%) anticipating a decrease in activity for 2024.

Still, it is likely that construction demand should begin to recover gradually in the second-half 2024, helped by improving financing conditions, the current downward correction of house prices, and structural factors such as pent-up housing demand, migrant needs, and additional public spending on transport, energy, IT infrastructure and the military.

Funds from the EU Recovery and Resilience Facility will help only modestly as Germany’s share of €28 billion (spread out over several years) represents only about 4% of the country’s annual expenditure in fixed investment.

In non-residential structures, construction spending is expected to decrease by 2.5% in 2024 because of the impact of weaker economic growth and high financing and building costs (Photo: AdobeStock)

Spending down

Real total construction spending in Germany has been falling since 2021. This downward trend is expected to continue in 2024 with a decline of 4.2% before growth returns in 2025 at 3.2%.

Residential construction in Germany is forecast to fall by 6.0% in 2024, but recover by 3.5% in 2025, despite an influx of Ukrainian refugees and other migrants that is fuelling demand for rental housing.

This reflects a deterioration in the purchasing power of potential homebuyers amid sticky core inflation and the ECB’s restrictive monetary policy stance that has fed higher mortgage rates.

The cost of building new residential buildings also remains high, even though the annual rate of inflation has eased since the start of 2023.

This, as well as the Building Energy Act mandating that every newly installed heating system in new-build areas must run on 65% renewable energy from Jan. 1, 2024, would also impact planned housing projects given the high upfront investment involved that only amortizes over the long run.

That said, households with low incomes may be eligible for a subsidy of up to 70% of the investment cost. Indicators of housing demand point to a sharp fall in the near term.

Surveys from the ifo Institute showed that 48.7% of companies reported a lack of orders in October, while the proportion of companies reporting cancelled projects rose to a record high of 22.2%.

Recovery on horizon

In non-residential structures, construction spending is expected to decrease by 2.5% in 2024 because of the impact of weaker economic growth and high financing and building costs. As with residential a modest recovery of 3.0% is expected for 2025.

Office construction will continue to face headwinds in 2024, and the completion dates of many existing projects are likely to be pushed back, while new build projects in the planning stages are unlikely to come through because of tighter financial conditions.

Jones Lang LaSalle Inc (JLL) reported that the volume of new construction fell by more than 30% year over year during the third quarter of 2023, as financing for speculative developments remained particularly strained.

That said, the shift toward hybrid working is increasing demand for high quality space, particularly in central locations, that meet environmental, social, and governance (ESG) requirements and, as a result, the refurbishment or repurposing of existing office space remains a key focus.

Even infrastructure construction spending is expected to contract 0.7% in 2024 before recovering 2.8% in 2025.

This is a significant change from history and prior outlooks and is largely driven by a court ruling forcing Germany to alter public spending.

While infrastructure benefits from the EU Recovery and Resilience Facility (RRF), only €2.25 billion (equivalent to 8% of the country’s €27.9 billion financial allocation) has been disbursed to date. Furthermore, the funding will be spread out over several years and will only modestly support near-term activity.