Staying cautious on European risk assets after Germany's election

Germany’s election results provide a degree of policy predictability, although talks to form a coalition government are likely to take time. However, with little hope for a material change in fiscal policy at a time of geopolitical challenges, key issues for the German economy remain. We keep our cautious outlook for European risk assets, and maintain our preference for fixed income in the region.

The conservative Christian Democratic Union/Christian Social Union (CDU/CSU) won 28.5% of the national vote. Far-right Alternative für Deutschland (AfD) rose strongly to 20.8%, while the Social Democratic Party (SPD) came third with 16.4%. CDU leader Friedrich Merz is set to become the next Chancellor, although with CDU/CSU short of an absolute majority, a coalition will be necessary.

A key point of uncertainty ahead of the election was whether a two-party ‘grand coalition’ by CDU/CSU and SPD would be possible, or whether a third party would be needed to clear the hurdle of 315 seats. In the event, benefiting from the failure of two smaller parties (liberal Free Democratic Party and left-wing Sahra Wagenknecht Alliance or BSW) to clear the 5% threshold needed to enter parliament, the two centrist parties jointly reached 328 seats, creating a slim but functional majority.

These results … should provide greater government stability and policy predictability

Political timeline

This leaves a likely baseline scenario of a centrist coalition CDU/CSU and SPD in the next government. The three-party coalition government that was in power until November 2024 proved particularly dysfunctional, and so we see these results as positive given that they should provide greater government stability and policy predictability.

Mr Merz’s call for a government in place by Easter (18-20 April) sounds ambitious, as negotiations have historically taken around two months on average, and as long as six months in 2018. But with two parties now commanding enough parliamentary seats for an absolute majority, and a recognition that the stakes are high, the coalition formation process should prove more expedient.

Economic implications

This was a high-stakes election, and saw the highest voter turnout since German reunification. The three-party coalition government that was in power since 2021 created significant discontent. The rise of far-right and euro-sceptic AfD to second place in parliament is a concern both in Germany and elsewhere in Europe. The geopolitical context is particularly complex, especially for Germany’s export-dependent economy, which has contracted in the last two years and faces additional risks from President Trump’s tariff agenda.

The economic circumstances are particularly notable, following two years of economic contraction and significant downside risks. Chronic under-investment has taken a toll, leaving serious infrastructure needs in areas including defense, digitalisation, and public transport. With the German economy underperforming its peers since the global pandemic and an increasing recognition of the need for additional funds, especially for defence spending, the political debate had recently shifted in favour of reforming the constitutional debt brake that has acted as a strict constraint on German fiscal policy.

The three parties in favour of a debt brake reform have failed to reach the majority necessary

Such a development could have led to a meaningful change in Germany’s macroeconomic policy. However, the three parties in favour of a debt brake reform (CDU/CSU, SPD, Greens) have failed to reach the two-thirds majority necessary to change the country’s constitution.

This makes for a more challenging fiscal outlook, as support from left-wing parties who are opposed to higher defense spending, or from the AfD, which is opposed to debt brake reform, is unlikely. While there is some potential for fiscal easing going forward, the absence of a strong majority in favour of reforming the debt brake means any such change will be of limited nature and possibly take longer to negotiate, meaning that ultimately any resulting near-term growth boost would only be modest.

Investment implications

The euro strengthened in the immediate aftermath of the German election. We believe currency markets had anticipated a two-party coalition, including expectations for a reform of the debt brake. Therefore, if there is any indication that reform is threatened, we would not expect the euro to maintain its recent resilience. The single currency faces significant macroeconomic headwinds, as the European Central Bank (ECB) delivers successive rate cuts in the face of a tepid economic growth in core European countries. We still see the euro weakening against the US dollar and Swiss franc over the next twelve months and so reiterate our EURUSD targets of 1.02 on a 3-month basis and 0.98 on a 12-month horizon, and EURCHF at 0.93 in three-months and 0.86 a year from now. Overall, we expect the impact of Federal Reserve and Trump administration policies, as well as China’s growth momentum, to matter more for the European currency.

It is high time to lock-in higher yields while possible

Yields on 10-year German Bunds remained largely unmoved following the election. However, with interest rates in the euro area still falling as the ECB eases policy, we see European sovereign bond yields falling, and believe that it is high time to lock-in higher yields while possible.

European stocks have recorded a strong start to the year. The STOXX Europe 600 index has gained 8.24% year-to-date. Under-owned by investors, European stocks have benefited from expectations that European stocks would benefit from an end to the Ukraine war. The ECB’s rate-cutting cycle has supported valuations. Immediately following the election, European stocks declined, with the exceptions of the German DAX and the Spanish IBEX. 

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In coming weeks, we expect some consolidation. The French stock market may outperform in the short term, given that German stocks look overbought. In addition to the ECB’s monetary easing, which supports valuations, a possible decline in global energy prices would restore some competitiveness to Europe’s industrial sectors.

From a geopolitical perspective, Mr Merz’s comment that Germany and Europe need to gain independence from the US risks putting the country on an economic collision course with the US. Trump administration tariffs on German goods, most likely on the auto sector, are possible. Meanwhile the banking sector, which has driven most of the European stock market performance this year, may slow in response to the ECB’s easing cycle. For these reasons, we keep a cautious view on the outlook for European stocks. We will closely monitor the evolution of the Ukraine war negotiations and discussions on the future of Germany’s debt brake.