March 2025

“The conversion rate priced labor out of the market.  East German companies suddenly had to pay the same nominal wages in a currency worth much, much more than the old Ostmark.” Rolf Langhammer

Memories of German reunification were rekindled in March, as an announced suspension of debt limits and talk of large deficit spending fueled the largest selloff in Bunds since 1990.  Economic reunification, which was accompanied by a one-for-one currency swap rather than at the three-to-one “official” FX rate or the black-market five-to-one rate, resulted in the permanent hobbling of uncompetitive east German industry and a compensatory DEM 2 trillion wealth transfer as compensation.  The resulting German inflation led to much higher interest rates as the Bundesbank sought to quell the monetary surge, which in turn had major consequences for the rest of western Europe. Other countries were forced to raise interest rates to double digits to support their currencies against the resurgent DEM, creating considerable economic headwinds.  Later in 1990, then-Chancellor John Major made the momentous decision to join the Exchange Rate Mechanism (ERM) at too high an FX rate just as high rates were starting to bite.  Persistent German inflation through 1991 and 1992 kept pressure on other currencies, both those formally in the ERM and those shadowing it.  This culminated in the spectacular car crash of Black Wednesday, September 16th, when the UK spectacularly exited the ERM, the Italian Lira was significantly devalued, and the Bundesbank began a slow rate cut phase.  In the following months, most other countries devalued their currencies as well, and a considerable recession ensued.  To be sure, the restrictive monetary conditions of the time were at least in part due to domestic pressures following the boom years of the late 1980s.  But the late-cycle inflationary surge caused by the fiscal profligacy that accompanied reunification had an outsized impact that is still felt today.

So is it right that the market equates the current German government’s announcement with the momentous events of thirty years ago?  Probably not.  The scale is not remotely similar, and it’s happening at a different point in the business cycle.  We will also need to see exactly how much is actually spent rather than plans announced.  However, it is worth noting that if this policy change is indeed implemented in the spirit in which it is currently indicated, then we can say that the last anchor of low debt fiscal management will have been raised, and having overcome the initial – and most difficult hurdle – Germany will begin the inevitable march toward the “100% debt-to-GDP” club, joining almost all the other major economies in that pantheon.

Concerns of higher German indebtedness were soon overtaken by the pending tariff storm set to be unleashed by the US administration.  Risk assets fared badly, with US equities continuing the correction that started in February.  There was considerable volatility in bond markets as uncertainty over the impact of tariffs on trade began polluting forward looking sentiment indexes, while current data showed highlighted resilience in the US and a bottoming out in Europe.  With policy makers seemingly on hold for the moment, future data releases once again will be important to the direction of interest rates.

The market paradox played itself out for European bank securities as well.  Higher bond yields were supportive for equities while credit and AT1s traded lower.  Clearly any signs of sustained weakness creeping in will weigh on bank stocks given lingering fears over NIM compression and the inevitable worries about future portfolio provisioning.  In our view any serious down move, especially in credit and AT1 securities would represent the first serious opportunity to add risk as the market has shown a chronic tendency to undervalue the extent to which bank balance sheets have been cleansed since the last downturn.  For the moment our fund maintains its current focus on idiosyncratic situations while retaining considerable flexibility in positioning.  Other than small tweaks composition of our portfolio did not change materially during the month, which saw the fund’s A shares rose +1.38% with equities contributing +101bps in gross performance and credit instruments +60bps.