Reasoning why the DAX is the lame duck

As one may have noticed, over the not so recent past the German benchmark index DAX has trailed its major European country equity indices. An investor who invested four years ago in the DAX would have lost about 4% while the French CAC 40 returned 21%. With Germany as so often being referred to as the European powerhouse, such a strong underperformance is rather puzzling at first glance. However, geopolitical tensions and comparing how the German equity index is structured compared to its European peers resolve the mystery rather quickly. The article refers to the former in the first part and addresses the latter issue in the second. To conclude the article we take a look ahead and answer the question whether the DAX is likely to trail the performance of its European peers.

Part 1: Export orientation hurts – but there is more to it

The end of the past calendar year marked the end to the worst year of the German DAX in a decade. In 2018, the German benchmark index lost more than 18% after falling briefly into bear market territory – defined as a 20% or more drop from a recent high – in December. Thus, 2018 ended with the worst quarter for the DAX since 2011 and recorded a its worst yearly performance since 2008, when it lost 40%. However, the struggles of the largest listed German companies don’t stem from issues arising from inside the German economy. As it is well known, Germany is one of the largest exporters in the world. According to data from the Worldbank, Germany exported goods in value of more than $1,046bn in 2017, making up roughly 46% of the German GDP. As the global economic cycle showed signs of losing momentum in the past year, this effected especially German manufactures of cyclical goods, such as cars or machine tools.  The GfK consumer confidence index consistently decreased over the course of 2018, showing the fear of consumers of an upcoming recession. For the first time since 2015, German GDP fell in the third quarter of the past year. Geopolitical tensions acted as a catalysator, with uncertainties arising from the US-China trade standoff or the Brexit that put investments to a halt. The big three German carmakers listed in the DAX, Mercedes, VW and BMW, have further been affected by the rageous American President who continuously threatened to slash tariffs on their cars. And as if that wasn’t already enough, costly affairs and public discussions about emissions tests added to the list, resulting in a streak of profit warnings from the car manufacturers – an industry that accounts for ca. 8% of the German GDP.
But there are also some homemade problems. The German banking sector, with its structural problems stemming from a construct of non-listed public and semi-public banks, showed its effects in the two largest German lenders. Struggling with shrinking the size of their businesses and restructuring, Deutsche Bank lost 56% of its market value in 2018. Deutsche Bank is kind of symptomatic for the German banking sector that faces strong headwinds.
Nevertheless, the country that was once known for its political stability added itself to the long list of European political stalemates. With political parties taking the country as hostage for their internal power plays, Germany is losing ground to follow through with important reforms and lead the European continent in troubling times.

Part 2: Taking a look at the characteristics of the major European equity indices

 After having explained some of the main reasons of the DAX’s underperformance that stem from geopolitical noise, we now want to look at some stock characteristics of the constituents and compare these to other major European equity indices. The indices are similar in size with a range of constituents between 25 and 50, with the FTSE100 being the only exception.  Looking at the table below, it’s quite striking to see how extremely the DAX underperforms its European peers. For the three time periods under consideration, the German benchmark index shows the worst performance among all three of them. The strongest performance have the Swiss Market, the French CAC 40 and the Dutch AEX 25.

An important characteristic when investing in any asset class is a risk measure of the investment, usually in the form of return volatility. The table below shows the annualized standard deviation of daily returns over the past 12 months. A lower return of an investment may be justified by its lower risk, stemming from the risk aversion of investors. However, DAX daily returns show one of the highest volatility levels among the peer group, contradicting a possible explanation for its underperformance. Very remarkable is the attractive risk-return profile of the aforementioned Swiss Market, CAC 40 and AEX 25. Not only do they show the highest returns, but also the lowest levels of volatility in their daily returns.
In the prior section, we mentioned the heavyweight of cyclical industries in the German benchmark as an explanation for its underperformance. To understand how the industry structure of equity indices influences performance, we analyse the composition by GICS sectors of the benchmarks under consideration.

With ca. 80% of its constituents operating in cyclical industries, the DAX shows the strongest concentration in that respect. As part of the Consumer Discretionary group, automobiles – and auto parts stocks lead the decline, with Continental halving its share price and Daimler losing over 35% in 2018. Material stocks, producers of chemicals or steel, make up roughly 10% of the German benchmark index and suffered painful losses, e.g. Covestro also halving its share price in 2018.
The Swiss Market shows quite the opposite image. Comprised by almost 70% of stocks in the Defensive sector, the Swiss Market is concentrated in stocks that belong to the outperformers in the past year, as investors allocated their money towards safe havens when volatility returned to equity markets. The Swiss index is dominated by the three heavy weights Nestle, Novartis and Roche (all three >30% 1Y return) which make up over 60% of its market capitalization. However, it’s not all rosy in the Swiss Market. Out of the 20 constituents, 7 show double digit negative returns on the one-year horizon, with Swatch (-26%), Credit Suisse (-24%) and UBS (-22%) at the top of the negative performers. The strong negative performance of over a third of its constituents doesn’t shine through on the index level, due to the dominance of Nestle, Novartis and Roche in the weighting scheme.
The CAC 40 has a particular overweight in consumer discretional goods. Luxury brands such as LVMH, Kering and Hermes make up ca. 18% of the French benchmark and experienced an increase in their stock prices south of 30% over the past 12 months. This shows how different the CAC 40 is allocated within cyclical consumer goods compared to the German benchmark. The strong allocation towards cyclical consumer demand, while very beneficial in the past, may impose future risks though.
Another remarkable difference between the composition of the German benchmark index many of its European peers is the tilt towards energy and utility stocks. While lacking any energy company among its constituents, the DAX comprises RWE and EON as its only two members from the utility sector. Despite showing a strong performance over the past 12 months (RWE +30%, EON +16%), the two utility companies account for only ca. 3% in the weighting scheme. Energy producers attribute to the performance of other major European equity indices in much larger portions. For example, in the Dutch AEX 25 Royal Dutch Shell has an index weight of ca. 28% (!) and with an appreciation of 16% over the past 12 months strongly contributed to the performance of the AEX 25. Royal Dutch Shell is double listed and also featured in the FTSE 100. The FTSE 100 further comprises BP (+28% LTM) with an index weight of roughly 5%. The Italian FTSE MIB comprises with Eni and Enel two stocks from the energy and utility sector, respectively, that make up each ca. 11% of the index and appreciated in price 16% and 25% over the past 12 months, respectively. The Spanish IBEX 35 benefited the most from the stark appreciation of utility stocks. With Endesa, Iberdala and Naturgy comprising roughly 17% of the index and appreciation in price south of 40%, they made up for losses of other constituents, mostly coming from the banking sector.

Summing up

We provided some reasoning for the poor performance of the German benchmark index DAX and looked underneath the surface to explain the discrepancies in the performance of the DAX to other major European equity indices. By comparing its large concentration in sectors that have been particular affected by geopolitical tensions and other problems described in the first part of the article, the outperformance by its European peers is less surprising, which were shown to be more diversified towards sectors that were more favourable in the past. But what used to lack performance in the past may promise future excess returns and may be an attractive investment for value-oriented investors. Looking at PE ratios, countries with good performing equity markets show high valuation levels, such as Switzerland, Netherlands or the Nordics, whereas Germany looks particular cheap based on that metric. We’re rather reluctant about expecting an improvement in the performance of the German benchmark index. With signs adding up that point towards a global slowdown, not the least the US yield curve inversion and the Atlanta Fed warning that US annual growth rate might be as low as 1.5%, even if the US and China will be able to resolve the trade issue, a slowing Chinese economy may only pose a limited upside potential. In addition, investors might have already priced in a positive outcome of the trade talks to some degree during the bull run at the beginning of this year, thus additional downside potential might be given, if the negotiations fail to deliver. The strong tilt towards cyclical industries thus may continue to way on German equities. Further, the ECB announced past week that the low interest rate environment is to stay, which doesn’t help German banks that struggle for years already to reform their business models. We therefore don’t expect the German benchmark index to turn things around with the struggle likely to continue.