Germany's chances lie in a two-party coalition
Germany has gone to the ballot box and decided in favour of a change of government. The election victory of the conservative Christian Democratic Union/Christian Social Union (CDU/CSU) is associated with the hope of new economic policy impulses. The good performance of the German stock market, on the other hand, remains influenced by external factors. In domestic politics, Germany needs to overcome the political and economic stalemate to support the stock market in the long term.
The victory of Friedrich Merz’s CDU was long anticipated. However, the upcoming coalition negotiations will be challenging as the parties have grown too far apart in recent years. A grand coalition between the CDU/CSU and the Social Democratic Party (SPD) seems most likely.
The election has improved room for manoeuvre
A future government can be formed by a two-party coalition. Depending on the personnel realignment of the parties, finding a consensus may have become a bit easier as a result compared to the previous legislative period. Nevertheless, the majorities in the federal parliament continue to allow for a so called “blocking minority” of the opposition parties, which could prevent a reform of the debt brake that might be considered. Major reforms will be difficult.
Friedrich Merz has distanced himself from the political guideline of a "policy of small steps", as coined by Angela Merkel, since taking over the chairmanship of the CDU in 2022. But Sunday's election result limits the possibilities for a big hit. Economic stimulus measures are expected in particular through moderate tax cuts, smaller labour market reforms, measures to reduce energy costs and higher military spending. The stimulus potential of such measures is estimated at only 0.2 to 0.4% of the annual gross domestic product.
Stock markets run ahead of domestic politics
On the stock market, the German stock index DAX climbs one all-time high after the next. However, the influence of the election on the market performance so far should not be overestimated. Most recently, external factors led to a return flow of international money into the German stock market after three years of investment money flowing out of the eurozone with the outbreak of the Ukraine war. On the one hand, hopes for peace in Ukraine and a reconstruction of the country are supporting the markets. On the other hand, the market is flirting with economic stabilization in China, which would also benefit the German export industry. But question marks remain.
Germany must strengthen its role in Europe
Looking ahead, the confidence of the capital markets could be improved in two ways: (1) a strengthening of political power in the EU, and (2) economic policy structural reforms.
The future German government has an important role to play in this. While the relationship between Olaf Scholz and Emmanuel Macron is known to be difficult, a strong German-French solidarity is needed. Threatening confrontations with the new Trump administration require uniform European responses – both on economic and military issues. Friedrich Merz has already given high priority to these issues on election night.
Economic policy structural reforms must address the loss of international competitiveness. The fiscal room for manoeuvre for reforms is limited. The discussion in the coming weeks will revolve around an increase in the debt brake anchored in the German constitution. The centre-right CDU/CSU and centre-left SPD have very different ideas about how to handle the debt brake and how to use the money.
Bond market looks nervously at Germany
The rating of Germany's creditworthiness at the highest level of "AAA" is still not at risk and was confirmed in January by the rating agency S&P Global. And yet, Germany has recently been viewed more critically in view of the economic stagnation and political crisis. Country risk is priced higher on the bond market, making future borrowing more expensive. While some commentators see the solution to many problems in raising the debt brake, the bond markets fear that Germany's debt service will grow over the coming years. The bond market is looking nervously at the upcoming coalition talks. In the event of a reform of the debt brake, it will take a critical look at the use of funds – funds that must be used for future economic growth.
Action is needed
For months, international investment money has been slowly returning to Europe. The Bundestag election in Germany can further consolidate this trend. The Christian Democrat election winner Friedrich Merz has put the economy at the centre of his election program. In contrast to the previous “traffic light”-coalition under Chancellor Scholz, Merz is likely to lead a two-party coalition, which will improve political stability.
However, in order to give the German and European capital markets new impetus, long-term structural reforms are needed. Despite Germany's solid budget situation, it seems difficult at this point in time to anchor economic policy breakthroughs in the coalition agreement. Spending limits and prioritization stand in the way. For the time being, the German election result remains a marginal phenomenon for the international financial markets – action is needed.