German Equities: A Near-Term Opportunity in a Turnaround Narrative

The German economy, long the laggard of the G7, has begun to shift gears. Recent data points to a confluence of macroeconomic and sector-specific tailwinds that could position German equities for a meaningful rebound. While risks remain—most notably from lingering U.S.-EU trade tensions—the alignment of improved business sentiment, fiscal stimulus, and monetary easing creates a compelling case for selective exposure.

The Ifo Surge: A Pivot from Pessimism to Cautious Optimism

The June 2025 Ifo Business Climate Index reading of 88.4—up from 87.5 in May—signals a pivotal shift in corporate confidence (see Figure 1). The improvement was driven entirely by expectations for future conditions, which jumped to 90.7, the highest since April 2023. This contrasts sharply with the subdued current situation sub-index (86.2), reflecting ongoing operational challenges but also highlighting a critical psychological inflection point.

Sectoral analysis reveals uneven but encouraging progress:
- Manufacturing: Sentiment improved marginally, with companies expressing optimism about future orders despite weak current demand.
- Services: The strongest gains, as businesses reported better current conditions and elevated expectations.
- Construction: Expectations hit a two-year high, though execution risks persist due to supply chain bottlenecks.

The turnaround in expectations is being fueled by two critical factors: the new German government's €100 billion infrastructure plan and €50 billion defense modernization fund, which began rolling out in Q2 2025. These measures are targeting sectors such as renewable energy, logistics, and tech-enabled manufacturing, creating a pipeline of projects that could lift long-term growth prospects.

ECB Rate Cuts: A Catalyst for Risk Appetite

The European Central Bank's June decision to cut the deposit rate to 2.00%—its first easing since 2016—has further bolstered investor sentiment. With inflation projected to average 1.6% in 2026 (below the ECB's 2% target), policymakers now have room to prioritize growth over price stability. The ECB's forward guidance, emphasizing a “data-dependent” approach, suggests rates could fall further in 2025–26.

This dovish pivot has already had a tangible impact:
- Corporate borrowing costs for German firms have fallen by ~50 basis points since March 2025, easing pressure on balance sheets.
- Equity valuations, particularly in cyclical sectors like industrials and construction, have become more attractive.

Trade Tensions: A Cloud, but Not a Ceiling

While U.S.-EU trade negotiations remain unresolved, the risk of a full-blown tariff war has receded slightly. The U.S. delayed its retaliatory tariffs on European goods until July 2025, and the EU's countermeasures—targeting $21 billion of U.S. exports—are also on hold pending diplomatic talks.

However, the threat of tariffs lingers, particularly in sectors like automotive and machinery. Investors should remain cautious in areas exposed to transatlantic trade, such as German automakers (e.g., BMW, Daimler), but the broader market is likely to absorb this risk as negotiations continue.

Valuations: A Bargain for the Bold

German equities are trading at a P/E ratio of 14.5x, near the lower end of their five-year average range (11.82–16.30). This discount reflects lingering concerns about structural challenges (e.g., aging demographics, high labor costs) but ignores the cyclical recovery underway.

The MSCI Germany Index is now 28% cheaper than the global equity market, a valuation gap last seen during the 2020 pandemic sell-off. For investors with a 12–18 month horizon, this presents a compelling entry point.

Sector Plays: Where to Look

1. Infrastructure & Renewables:
2. The government's €100 billion infrastructure plan will boost firms like HOCHTIEF (construction) and RWE (renewables).

3. The Frankfurt-listed ETF Xetra DAX Infrastructure (DBAA) offers broad exposure.

4. Services & Consumer Discretionary:

5. The services sector's strong performance points to opportunities in travel (e.g., Lufthansa) and retail (e.g., Metro AG).

6. Cyclicals with Leverage to Rate Cuts:

7. Banks like Deutsche Bank and insurers such as Allianz could benefit from lower funding costs and improved risk appetite.

Risks and a Word of Caution

• Trade Tariffs: A failure to resolve U.S.-EU disputes could hit exports and growth projections.
• Structural Challenges: Germany's aging population and reliance on energy-intensive industries remain long-term headwinds.

Investment Recommendation

For investors seeking near-term upside, we suggest a 5–10% allocation to German equities via the iShares MSCI Germany ETF (EWG). This ETF offers diversified exposure to DAX constituents and key sectors. For those willing to take sector-specific risk, FLGR (Franklin FTSE Germany ETF) provides a tilt toward smaller-cap firms with higher growth potential.

Conclusion

The German equity market is at an inflection point. Improving sentiment, fiscal stimulus, and accommodative monetary policy are aligning to create a favorable environment for a rebound. While risks like trade tensions and structural challenges remain, the valuation discount and sector-specific catalysts make this a compelling opportunity for investors with a medium-term horizon.

Act now—but stay nimble. The German recovery is underway, but its trajectory will depend on policymakers' ability to navigate both domestic reforms and global headwinds.