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German elections this weekend will be an important focal point for markets. We do not expect any major surprises, and would expect a coalition government to be formed, made up of the Christian Democrat Union/Christian Social Union (CDU/CSU) and Social Democratic Party of Germany (SPD) parties, with Friedrich Merz as Chancellor.
The critical aspect to watch out for is the momentum of the far-right Alternative for Germany (AfD) party, although we do not expect that party to be welcome into any coalition talk. It might take weeks to form a coalition government, which is customary in German elections. The more important aspect will be to assess how the new Chancellor will be tackling the various challenges, both domestically, and internationally.
Domestically, the new government will be facing an economy in recession or quasi-recession since 2023. With industrial production growth contracting for four years in a row, a business climate Institute for Economic Research (IFO) survey at lower levels than during the Covid crisis, and at levels last seen during the Global Financial Crisis of 2008-09.
Internationally, the challenges of an uncertain dynamic on tariffs, growing trade tensions, ongoing geopolitical risks inside Europe and outside. Not to mention an important ceasefire negotiation between Ukraine and Russia on which Europe is not actively involved, the question of increased defence spending, and securing stable access to energy supplies, will all be on the radar to tackle rapidly.
The elections could however lift yet another geopolitical uncertainty for Europe, which could further shed light on the relative attraction of European equities, even if other uncertainties will still linger, notably related to tariffs and trade tensions with the US.
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Depending on the results, the coalition might have to be made up of more than two parties, to get over the 50% mark, with additional smaller parties potentially playing an important role.
Coalition of centre-right most likely, with Friedrich Merz as Chancellor
German snap federal elections on 23 February will be another important focal point for investors and for Europe, even if it is not gathering much attention with investors and the market, who have been too busy grappling with the ongoing policy announcements of US President Donald Trump’s new administration. Germany, in a similar manner to other countries in Europe, is likely to shift slightly to the right. Even if it is unlikely that the AfD extreme right party, which is now second in polls, will be invited to join a coalition, as mainstream parties will likely refuse to do so.
We will likely be left with a CDU/CSU-led coalition with the SPD, most likely headed by leader of the CDU/CSU and ex-BlackRock employee Friedrich Merz as Chancellor, which might be supportive for European equities. The centre-right CDU/CSU party is leading in the polls, with c.29% of voting intentions, whilst AfD is second with 21% of voting intentions, and centre-left SPD is third at 16%, leaving the Green Party in fourth position with 13% of voting intentions.
The Left is polling at 7%, with Sahra Wagenknecht Alliance (BSW) at 5% and Free Democratic Party (FDP) at 4%, with the latter two parties being uncertain to enter parliament, if they do not reach the 5% minimum share of votes.
Voting intentions - German polls
Source: Politico as at 17 February 2025.
Depending on the results, the coalition might have to be made up of more than two parties, to get over the 50% mark, with additional smaller parties potentially playing an important role. This could lead to a more difficult situation in terms of agreeing and driving policy initiatives for the new upcoming German government, once it is formed. Depending on the negotiation dynamics between various parties, forming a coalition government might take weeks, although this would be considered a normal part of the process for German elections, and therefore is unlikely to be a worrisome matter for markets, in our view. The Bloomberg analysis below shows that on average, since the 1990 elections, Germany has taken c.60+ days to form a coalition government, although this has taken longer with the last three elections.
Length of time to form German coalition governments since 1990
Source: Bloomberg as at 31 January 2025.
Wild card of an AfD-backed government is unlikely
European political elections have got us used to surprise outcomes. In this instance, the surprise outcome would be a strong enough showing by extreme-right party AfD, and a coalition government that would have that party within it. This is a very low probability event, based on the current polls, and would lead to a negative market reaction, on the basis that the market would question the long-term political future of the EU. It would be a further significant shift towards the far-right for yet another key EU member country.
Plenty to tackle for the next Chancellor both domestically and internationally
The new Chancellor will be taking over in a difficult economic environment, with the German economy being in recession for the past two years (2023 and 2024, with -0.3% and -0.2% GDP growth respectively), and expected to barely grow this year, with a consensus expectation of +0.3% GDP growth in 2025. The all-important industrial production has been contracting every year since 2022, and is expected to continue to contract in 2025, with a consensus forecast of -0.3% growth1.
Business sentiment is also weak in Germany, with the German IFO Business Climate index reaching weaker levels than during the Covid crisis, and at levels last seen during the GFC.
IFO German business climate survey
Source: Bloomberg and IFO as at 20 February 2025.
The new German government will have plenty to tackle on the international scene, with Trump policies continuing to come through, and an ongoing backdrop of increased trade tensions. The geopolitical scene will likely also be important to tackle, with both the Ukraine/Russia ceasefire progress, the need for the EU to get involved in the negotiations to ensure the right outcome for the economic bloc, and the ongoing need to tackle energy supplies, to ensure reliable and predictable access to energy.
The most critical internal point to tackle for the German economy and for investors will be a more flexible approach to managing government spending, to bring in a better counter-cyclical flexibility. This will be an important focal point for us, as it could trigger further down the line a move towards a more centralised European budgeting, and easing of the tight budget constraints imposed by Brussels on member states.
At the moment, Germany has the lowest government debt to GDP ratio of any of the G7 countries, at c.63%, and a very low budget deficit of -2.2% of GDP in 2024. This is expected to be -2.0% in 2025, as a result of the constitutionally-embedded limitation to overspending2. The current limitations of 0.35% of GDP for structural budget deficits, which act as a debt brake, are likely too stringent, and do not allow Germany to spend on critical long-term spending related to infrastructure upgrades in particular. Merz has in the past mentioned that he would be open to look at reforming the debt brake rule.
A potential political uncertainty lifting, valuation attraction of EU equities could become more apparent
Post the formation of a new coalition government in Germany, it will lift one more political uncertainty for Europe, at least for the time being, which could further bring to the forefront the valuation attraction that European equities are currently sitting on. This is compared to the historic ranges, shown in the chart below.
Forward P/E (FY1) across regions over the last 20 years
Source: FactSet as at 31 January 2025.
This is in sharp contrast to US equity valuations, which are at historically very demanding levels, and which require a positive earnings momentum to justify. We have been arguing recently that, yes, there is US exceptionalism in terms of economic growth prospects and corporates earnings growth differential compared to Europe and emerging markets, but this exceptionalism also translates into a significantly high valuation level.
Further lifting of political and geopolitical uncertainties in Europe and in China in particular, could make these regional equity markets appear more appealing to investors who could see a potentially favourable risk reward.
Sources
1Source: Bloomberg as at 20 February 2025.
2Source: Bloomberg using consensus estimates of GDP as at 20 February 2025.
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