| German industrial production |
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| Source: Independent Strategy |
The fall of German finance minister Oskar Lafontaine is bullish for German financial assets, but only in the short term. Euroland remains a slow-growth region. So, after a brief rally, I reckon the euro is set to weaken again against the US dollar, moving towards parity. The European Central Bank will now be much less reluctant to cut interest rates in order to fend off EU recession. There's no justification for maintaining real rates of 2% to 2.5% when real GDP growth in the euro zone is sub-par and slowing and inflation below 1% and falling. Short rates could go 50 to 75 basis points lower by the year-end. That will help German Bunds and equities, which have underperformed the EU average by over 10% so far this year. That performance gap will narrow quite quickly.
Whether this leads to a sustained period of German equity outperformance, however, depends upon the extent to which the German chancellor, Gerhard Schröder, can seize the initiative and push through a more radical, pro-business, tax reform.