The economic engine of the EU (Germany) is weakening. The problems are deeper than the obvious.

Germany has been Europe’s economic engine for decades, pulling the region out of most crises. But this resilience is crumbling, and this poses a danger to the entire continent, including markets.

Decades of misguided energy policy, the demise of the internal combustion engine car, and the slow transition to new technologies pose the most fundamental threat to the nation’s prosperity.

Unlike 1990, the political class lacks the leadership to address the structural problems that are eating away at the heart of the country’s competitiveness. Berlin has shown a knack for overcoming crises in the past, but the question now is whether it can pursue a sustainable strategy. The outlook seems dim.

Chancellor Olaf Scholz’s makeshift coalition returned to minor domestic issues – from debt and spending to heat pumps and speed limits – as soon as the risks of energy shortages subsided. But the warning signs are becoming harder to ignore. Data released Thursday showed the economy has actually contracted since October and has expanded just twice in the past five quarters.

Economists expect German growth to lag behind the rest of the region for years to come, and the International Monetary Fund estimates that Germany will be the worst-performing G7 economy this year.

The risk is that the latest economic data are not isolated cases, but a sign of problems to come. Germany is proving ill-suited to sustainably serve the energy needs of its industrial base:

• Too dependent on old engineering;
• Lack of political and commercial flexibility to move to faster growing sectors.

Industrial giants such as Volkswagen AG, Siemens AG and Bayer AG are surrounded by thousands of smaller Mittelstand companies, and the country’s conservative spending habits put it on a stronger fiscal footing than its peers to support the coming transformation.

The most pressing issue for Germany is the implementation of the energy transition. Affordable power is a key prerequisite for industrial competitiveness, and even before the end of Russian gas supplies, Germany had some of the highest electricity costs in Europe. Failure to stabilize the situation could lead to an influx of producers heading elsewhere for more favorable locations.

The answer to that problem was a cap on electricity prices for some energy-intensive industries like chemicals, a plan that could cost taxpayers up to 30 billion euros ($32 billion) by 2030. But that would be a temporary fix and shows Germany’s desperate supply situation.

After closing its last nuclear reactors and insisting on phasing out coal as soon as 2030, the country installed about 10 gigawatts of wind and solar power last year – half the pace it needs to meet climate goals.

The administration aims to connect an estimated 625 million solar panels and 19,000 wind turbines by 2030, but promises to speed it up have yet to materialize. Meanwhile, demand is expected to grow due to the electrification of everything from heating and transport to steelmaking and heavy industry.

The harsh reality is that the resources to generate so much clean energy are limited in Germany due to its relatively small coastline and lack of sunshine. In response, the country is seeking to build a vast infrastructure to import hydrogen from Australia, Canada and Saudi Arabia – relying on technology that has not been tested on this scale. At the same time, Germany will need to speed up the construction of high-voltage grids connecting offshore wind farms in the north to energy-hungry factories and cities in the south. There are too few ways of storage to ensure that the country can withstand disruptions.

Europe’s powerhouse economy seems to have a well-funded and established idea generation system to keep its economy on top. R&D spending ranks fourth in the world after the US, China and Japan. About a third of patents filed in Europe come from Germany. However, much of the power of innovation is embedded in large companies such as Siemens and Volkswagen and is focused around well-established industries. While small manufacturers are still thriving, the number of new start-ups is declining in Germany – in contrast to the growth seen in other advanced economies.

Funding is also an issue. Venture capital investment in Germany will amount to $11.7 billion in 2022, compared to $234.5 billion in the US. Germany also operates under a heavy academic system and does not have a single university in the top 25 of the latest Times Higher Education rankings. Patent data shows that Germany’s ability to remain at the forefront is fading. In 2000, the country was among the top three for world-class patents in 43 out of 58 key technology categories, but in 2019 it achieved this spot in less than half of the fields.

Germany’s fading technological advantage is nowhere more evident than in the automotive sector. While brands like Porsche and BMW defined the era of the internal combustion engine, electric cars in Germany are struggling. BYD Co. overtook VW to become the best-selling car brand in China last quarter. The key to its push was an electric model.

Much of Germany’s wealth and social order is underpinned by a vibrant manufacturing sector that provides well-paying jobs. But that power has led to a dangerous dependence on overseas markets for supplies and raw materials — primarily China.

Much of Germans’ money is held by a network of around 360 public sector savings banks, so-called Sparkassen. These institutions are controlled by local communities, giving rise to potential conflicts of interest while weakening the country’s financial strength. Germany’s two biggest listed banks – Deutsche Bank AG and Commerzbank AG – have been mired in controversy for years, and although they are recovering, they are still undersized compared to their Wall Street peers. Their combined market capitalization is less than one-tenth that of JPMorgan Chase & Co.

In technology, Germany’s biggest player is SAP SE, which dates back to the 1970s and makes sophisticated software that helps companies manage their operations. There are no new national champions on the horizon. Digital payments company Wirecard AG briefly filled that role before collapsing in a sensational accounting scandal. The conditions are not promising. The lack of investment in Germany is particularly acute in digital technology. Despite an infrastructure that ranked it 51st in the world for fixed internet speed, Germany had the fourth lowest costs among OECD countries relative to the size of the economy.

Recent studies show that 50% of businesses cut production due to staffing issues, costing the economy up to $85 billion a year.

This year, more than 1 million Germans will reach retirement age – about 320,000 more than are becoming adults. By the end of the decade, Germany’s employment agency says the shortfall will grow to 500,000 – roughly equivalent to the city of Nuremberg, adding to the strain on the economy. In a recent report, the OECD made clear the scale of the challenges: “No major industrialized economy has had such problems at the core of its competitiveness and sustainability”

This in turn will cover the entire continent. The health of the German economy is critical to the wider European economy and markets. Things have already gained solid momentum and will be hard to reverse. In the long run, Germany could drag Europe’s economy down if things don’t change. As traders we can take advantage of this situation. The German index is on the ATH as the economy continues to slow. Combined with high interest rates, banking concerns and still persistent inflation, in the medium term the market is at a divergence from what is actually happening. The ECB is still raising rates and the path to 2% inflation is quite a bit longer than in the US, this suggests that European markets are a bit overvalued at the moment, just because of the recovery of the Euro, the resolution of the energy problems and the more stable economy for now . If inflation does not slow down sharply enough for interest rates to fall, money will flow out of Europe.