Highlights:
  1. Equities clearly remain in demand
  2. Greece, China and the Fed – What now for Volkswagen?
  3. Role of monetary policy
  4. Low DAX valuations
  5. Implications of Volkswagen drawdown vs GDP prospects through large scale immigration
  6. The DAX from a technical perspective

Equities clearly remain in demand

Without a doubt, equities remain in strong demand due to the current low interest environment. Both the loose European monetary policy and the current postponement in the interest rate increases in the US have generated a flood of liquidity in the markets, leaving investors searching for returns. On this basis, the DAX (German Share Index) should potentially be able to continue the upward trend of the past few years well into the future. In Q4 however, the current market correction may continue to unfold with volatility remaining high. Recently we saw several factors that once again drove the DAX below 10,000, which equates to a drop of more than 20 percent from the high of 12,400 in April. In order to provide an outlook as to the potential for further declines in Q4, we examine both the reasons for the DAX correction and the potential drivers that could unfold in the final three months of the year.

Greece, China and Fed – What now for Volkswagen?

The market has had to contend with a trifecta of concerns this year, and by and large managed to deal with all of them, as first Greece, China and then the Fed kept investors on edge. The worry is that the Volkswagen scandal could provide the catalyst and be the proverbial straw that broke the camel's back. First, there was the uncertainty surrounding the aid package for Greece and then came the question as to whether the country would be able to remain in the Eurozone. A recovery started after creditors and the Greek government was able to reconcile their differences and then came another major blow to the markets. Weak Chinese growth generated serious disruptions on the Chinese stock markets. As the second largest economy in the world with a sizable capitalization, the tremors in the Chinese stock exchange could be felt all around the world. The increasing speed of currency devaluation also played an international role as the yuan surprisingly dropped in value. Uncertainty about US monetary policy outlook also acted as a drag on any further price gains. As we saw in the market reaction – after the Fed failed to raise rates at the last meeting of the open market committee – a small increase in interest rates had already been priced into the markets. Instead, the Fed shifted the focus of market participants to global economic worries, particularly China, and thus spread market uncertainty about the future US monetary policy. Investors do not like uncertainty and appear to have lost their trust in the Fed.

Implications of the Volkswagen drawdown vs GDP prospects through large scale immigration

The outcome of the emissions-scandal that started with Volkswagen and may include other German and European carmakers is hard to assess at such an early stage. Recent analysis showed that if you were to put all Volkswagen brands together and include sub-contractors, around 500,000 to 600,000 workers or around 1.5% of all employees in Germany depend in some way or another on Volkswagen. And that’s just Volkswagen. If you consider that 1 out of 6 jobs in Germany depend in some way on the car industry and around 18% of the exports, the potential draw down effect seems hard to overestimate. Especially, if other German car makers were also trying to deceive, the brand “Made in Germany” as a whole could be seriously damaged. If it was only Volkswagen that manipulated emissions data, then the damage to German growth prospects could be curtailed. But it also remains to be seen if Europe’s biggest car maker can weather the upcoming storm of fines and shareholder lawsuits. A factor which currently is frequently neglected but which will likely factor in valuations over the next few months is the massive inflow of refugees to Europe, and in particular to the German-speaking countries. The German government is forecasting an inflow of 800,000 asylum seekers this year and the flow will most likely continue in the coming years. Short-term and medium-term spending by the German government in order to cope with the influx may act as a positive stimulus for the German economy. Immigration may transform into a miniature stimulus program and various institutions have predicted it could add 0.2 percent to growth in the German gross domestic product (GDP) in 2015 alone. While calls by the IMF, the US and European neighbours to spend more money have remained relatively unheeded and Germany has remained committed to a balanced budget, the country has few options but to react to the increasingly acute situation. Estimates for accommodating and feeding the immigrants are about 12,000 euros per person with some tending to be even higher. One aspect destined to play an important role in coming years is the easing of pressures on German labor markets. Until recently, German labor market scarcity was so severe that companies were having ever greater problems in finding people to fill job vacancies.

Role of monetary policy

The biggest surprise in August was the Chinese Central Bank's move to devalue the yuan to improve China's competitiveness. However, the devaluation of the euro after the most recent ECB press conference and the increase in the US dollar in anticipation of the upcoming interest rate hike in the US more or less eliminated almost half of this weakness in the yuan. The uncertainty surrounding US monetary policy – where an interest rate rise may take until next year – will probably take away some of the upward pressure on the US dollar and may also relieve some pressure for the yuan. As German companies are particularly exposed to China, the hope of a stable economic outlook in China may also benefit the DAX. The ECB may also be tempted to dampen appreciation of the euro. As early as their meeting in September, the bank signaled a willingness to expand the government bond-buying program by lifting the limits on single country government bond purchases from 25 to 33 percent of the newly issued volume. In a recent Bloomberg poll, 68 percent of respondents stated they expect the ECB to extend government bond buying programs until December. On equity markets, such actions may serve to underline the lack of alternatives and act as a further stimulus.

Low DAX valuations

If we see the easing of fears and risks or actual improvements in any of the situations listed above in the coming months, a recovery rally may start on the DAX, as sentiment is the worst it has been in a long time. A lot of pessimism is already priced in for China. On the plus side, the loose ECB monetary policy, a weak euro and low commodity prices provide a solid argument for a potential year-end rally on the DAX. The current levels indicate very low valuations relative to historic averages. The median average price to earnings ratio for the DAX index since it was started in 1988 has been 13.3. The current average P/E ratio of 12 indicates potential for gains, as this is a 10 percent discount relative to the historic average. Based on the historical P/E average, the DAX should potentially now be at 11,500.

The DAX from a technical perspective

The technical perspective on the DAX gives reason for concern, as the trendline from 2011 is under attack. If the trendline from 2012 is broken, then we might see a move towards the 8,680 level, a test of the 50%-retracement. Currently the level of 9,300 is one that stands out. However, it appears more likely that the DAX may test somewhere between the year's previous low point of 9,300 and the October 2014 low of 8,350. A growing divergence is currently found between the weekly chart and its MACD, which suggests the market is getting oversold. The 200 week average, which is running through the zone between 8,350 and 9,300, may also have a stabilizing effect. Subsequently a push back towards the 10,000 may be seen. As mentioned above, and with the German emissions scandal taken out as the big question mark, the DAX may remain attractive. Therefore, by year end, a rebound back into the zone between 10.000 and 11.000 may be seen. If the data from China were to improve markedly or a massive economic stimulus program start, even a jump above 11,000 potentially wouldn’t be impossible. In view of recent uncertainty, especially surrounding China and the drawdown of the Volkswagen scandal, stabilization of the DAX at the end of the year between 10,000 and 11,000 remains the most likely outcome. For further comment from Andreas Paciorek, please call +49 (0)69 2222 44023 Follow CMC Markets on Twitter: @cmcmarkets_de Follow Andreas Paciorek (Market Analyst Germany and Austria) on Twitter: @apaciorek_CMC CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.