Germany: Dawning of the age of equities

The German markets displayed a new-found dynamism in 1996 shedding a reputation as a haven for the cautious investor. The successful Deutsche Telekom sell-off and growth of 28% in the Dax index were the most obvious indicators, but the market also witnessed an uncharacteristic volatility including a four per cent fall in one day.

Though German equities are showing a certain Anglo-Saxon tendency it is not so much the market but the context that it operates in, that is entering a state of flux, with a pressing need for legislative reform. A successful reform will underpin the new pro-equity culture.

The most headline-grabbing change is the conversion of the deutschemark into the Euro in under two years time. Analysts largely agree that the trend towards considering industry sectors on a Europe-wide basis will accelerate and that competition be-tween markets will intensify. While Frankfurt is clearly becoming more competitive they are loathe to pick winners and losers. However the Euro’s introduction is not the only significant development.

Income and corporate tax is being reviewed, companies are restructuring and addressing shareholder concerns, while it is accepted that the state and companies’ pension provisions must change. Germany’s pensions time bomb is fast achieving the status of a cliché as the age pyramid looks set to render most European PAYG systems unsustainable. There is a reluctance to tinker with the ‘treaty between the generations’ but reform in this area is inevitable.

Helped by the massive advertising blitz accompanying the successful sell-off of Deutsche Telekom, the German public are being weaned from reliance on savings and insurance policies and through them the bond markets and into equity. Adding credibility to the ad men’s pitch is the reality of bond returns at six per cent while most fund benchmarks require returns of seven. Investment, pension and mutual funds should all be moving to hold more shares.

Many required changes depend on government and Bundesbank policy and they are not always fast acting: there are no proposals as yet to end the penalisation with double taxation - income tax and capital gains - of private pension funds.

But the Frankfurt Börse, which accounts for 75% of German trading, is being proactive, continuing to look for new efficiencies in a bid to compete, post-Euro. Changes include the setting up a Neuer market for young innovative companies and the replacement of IBIS with a fully electronic system by the end of the year. It is also lobbying for tax reform.

A Börse spokesman says: “”We are working like many different lobbying groups to persuade government to cut out a lot of taxation, allowing people to invest a significant amount for their retirement tax-free each year.””

Despite the uncertainty most analysts agree that equities have good medium-term prospects.

Peter Worel an investment analyst at Bayerische Landesbank in Munich predicts an upward trend in the Dax due to good prospective earnings in 1997, and the increasing adoption of international balance sheets by German companies. “Nevertheless it is necessary to select shares from sectors like chemicals, automobiles and electronics,” he says. In these sectors, selected blue chip companies have a good chance of share price increases because of international interest, but he cautions: “It is very important to look at company earnings. It is a great fantasy that these earnings will rise further in 1997.”

The sustained appeal of equity will bring in private investors: “When the market has gone up for a long time then private investors discover shares as an interesting medium,” he says.

Lothar Wepler, managing director at Oppenheim Finance, says that many investors are currently standing on the sidelines. He emphasises the foreign presence: “Nearly every move on the Dax has been accompanied by strong foreign buying. In 1996 this trend has not only concerned the market as a whole but also individual stocks.”

He believes that the introduction of a totally electronic trading system will be beneficial but is sceptical about the vaunted Neuer market: “The market capitalisation is really very small. It is very optimistic to suggest that this market will succeed.”

He wants to see increased liquidity from IPOs, but does not accept that the decrease in offers from 19 in 1995 to 10 last year was because the markets were concentrating on Deutsche Telekom. Many companies, he says, are not yet willing to go public. “There is enough money available to increase market capitalisation by 60 per cent.” he adds.

Thomas Holmes, chief strategist at Schroder Munchmeyer Hengst (SMH) largely agrees with Wepler, describing investment patterns as erratic. The major sources of demand internationally are the UK, US and continental Europe. Last year, UK in-vestors moved from an underweighted position to what, he says, they would consider as normal for their organisations. But despite foreign interest he says: “The longer term prospects for Germany de-pend very strongly on buying by German investors.”

He reserves judgement on Deutsche Telekom describing it as “the end of the beginning” of a new pro-equity culture, while pointing out that over the past 25 years personal equity holdings (including mutual funds) have declined from 11% to five per cent, despite an eight-fold increase in wealth. However this trend is reversing.

The head of equity research at BZW in London, Gebhart Klingenstein recommends the German market in the long term though says the Deutsche Telekom offer was for “”the man in the street”” saying that equity achieved similar popularity following 1960s share offers. In contrast with Wepler, he be-lieves that many Mittelstand will go public to gain access to the financing available from the market and that several companies may have held off until after the Deutsche Telekom on the advice of investment bankers.

Karl Hancock, a European equity strategist at Nat West Markets in London, says recent German liquidity, is a result of increased international funds moving to Germany, including the US because of its high investment involvement. He also highlights restructuring in sectors such as chemicals.

However for those who hope privatisation will greatly increase trading volumes, he points to the UK experience where many privatisation shares were held for long periods, benefiting institutions without significantly affecting selling.

He does see the possibility of a virtuous circle arising from pensions reform: “Those private pension funds will not only invest in bonds but also in equities, increasing liquidity and pushing stock markets higher. This may encourage more Mittelstand into the market.”

Dr Jorg Hahn, head of German equity funds at Deutscher Investment Trust believes that Germany has established a positive economic momentum, citing structural changes and restructuring discussions about shareholder value, share buy-backs, and company tax reform.

The market, he says is not that strong with particular underperformance from the more domestically oriented MDax (70 Mittelstand shares) in comparison to the export-oriented blue-chips. Deutsche Telekom is now a share on a par with Siemens or Volkswagen, although he points out wryly that privatisation came ten years after British Telecom.

He predicts higher trading volumes long term although the change may not be apparent this year.

“I think we will have another type of equity culture, with a higher percentage of private and institutional investors. Mutual and special funds will provide an inflow of money into equities, especially from the US, but also from Germany,” he adds.

German politicians have acknowledged the need for pensions reform, but fund managers and analysts, however, taking solace in the numbers, do not doubt that change must come.

Klaus Moessle, deputy managing director with DEGEF, a Deutschebank investment subsidiary says that the trend is clear: “The state system is getting weaker, placing more importance on private pension provisioning.

“Within our three pillar system of state, company and individual pension savings there will be a greater focus on the latter two,” he adds.

Moessle says that major German companies such as Siemens are looking for tax neutral ways of external funding including deferred compensation taxation for employees. He cautions against placing mandatory regulations on company pensions. “It is my prediction that if unattractive legislation came about then companies would rather stop their pension plans than swallow unattractive requirements.”

The funded Pensionskassen are valued at DM105 bn ($64.6bn), but only have a limited attraction. The company can deduct contributions as a legitimate expense but it is considered as taxable income on the employees’ side.

Larger companies have been using the Spezialfonds (Special funds) and DEGEF is a market leader in their management. Moessle explains: “These companies are using special funds for investing liquid assets into the capital market. It is not external funding but it is a funding of reserves through company assets. It does not protect the employees in the first instance, but it does protect the company.”

With the real benchmark for funding assets of pension reserves at seven per cent and ten year government bonds bringing a return of six per cent, the way forward, he argues, must be through equity.

The same difficulty arises for insurance companies. They guarantee a return of 3.5% but marketing is fo-cusedon the actual return and they calculate on se-ven per cent. In the past, buying long term government bonds would have delivered seven per cent through cyclical interest rate changes, but this pattern may be breaking down while returns from pro-perty in the last ten years, have fallen from ten per cent to five. The implication is clear: a move to equities.

Lothar Wepler, at Oppenheim Finance suggests that many individuals in Germany have assessed the pensions time-bomb themselves. “People are putting money in investment funds, for the purpose for securing their lives after retirement. German investment managers have a huge amount of money under management, not only for institutions but also for private investors.”

SMH’s Holmes describes what is at stake: “If we get one per cent of the private investors to move one per cent of their financial wealth, then it will represent about five per cent of the stock exchange’s total value. At the margins where the markets are made, this makes a big difference.”