Europe's Bad Apples Threaten to Spoil the German Core

Germany is the engine of the Eurozone.

Admittedly, even when it's firing on all of its smooth, "vorsprung durch Technik" cylinders, it's still not quite powerful enough to propel the clanking jalopy that has become the region's economy.

Now though, it seems, the rusting parts of the European chassis seem to be bleeding into the German engine. The only question now is when the wheels are going to fall off.

European's manufacturing economy slipped deeper into its debt-crisis funk last month, with activity, as measured by Markit's Purchasing Managers' Index survey, sinking well below the "maginot line" of 50 that separates expansion and contraction for overall GDP growth. The lack of output - not to mention confidence - in countries more focused on debt and deficit reduction than job creation pushed the Euro area jobless rate to a 15-year high of 10.9 percent. In crisis hit Greece, the figure is closer to 22 percent. In Spain, nearly a quarter of the working population is pounding the pavement instead of hammering paycheques.

"In Sum, this is definitely a bad start for Q2," said Barclays economist Francois Cabau. "Although the final estimate of the services sector index is still to be released, we think that we are likely to see downside risks to our baseline scenario of an onging recovery (this year)".

Tragic, without question, but hardly surprising: past data has been pointing to a marked slowdown in output for several months now, and the depths of the April readings are very likely to be tested further as austerity chokes-off growth, banks pull-up the shutters on new lending and companies circle the cut-cutting wagons.

What caught some by surprise, however, was the apparent contagion into German. Manufacturing activity dipped a full two points from March to April, according to Markit data, while the Federal Labor Office said unemployment grew by 19,000 to 2.8m, a rate of 6.8 percent that's been holding uncomfortably steady for five consecutive months. (although hotly disputed because of its construction, it's still a 20-year low).

"It is hard to dispel the impression that the deepening recession in Southern Europe is having a marked impact on German manufacturing performance," said Societe Generale's European economist James Nixon in a research note.

Growth for this year was hardly predicted to roar: Germany's Economy Ministry pegs GDP expansion at 0.7 percent following a 3 percent advance in 2011. But the rotting edges of the Eurozone - where most of Germany's exports ultimately arrive - can't help but affect its economic performance. Especially if China puts the breaks on its own speedster now that property prices in the world's second-largest economy are starting to look positively bubblicous.

Broader Europe? A recession beckons for this year at least and all bets for 2013 are essentially off.

Thus far, German bosses are sanguine. The Ifo index of business confidence hit a 9-month high last month while investor optimism, as measured by the Munich-based ZEW sentiment survey has advanced each and every month this year - even as the debt crisis around the region has intensified.

Clearly, many are looking to the United States to pick up some of the slack, and Tuesday's Institute for Supply Management manufacturing data - similar in scope to Markit's PMI readings - showed an April surge in expansion that surprised investors all over the world and lifted the Dow Jones Industrial Average past its four-year peak of 13,279. If growth and jobs improve - and the Euro weakens against the greenback - German exporters might just offset the European rust.

But not many are betting on a big US economic comeback. Job creation remains limp, debt levels crippling and this fall's Presidential elections promise partisan gridlock in Congress alongside polarising debate on the nation's televisions.

Put together, it looks as if Germany's going to need to downshift its own expectations in the coming months. Creeping borrowing costs in Spain and Italy, elections in France and Greece and a potentially cat-amongst-pigeons referendum on Europe's fiscal treaty in Ireland provide more than enough headline risk for cautious investors.

The DAX is up 11.8 percent so far this year. Might be time to sell in May and ... well, you know the rest.