What’s the story?
The preliminary results from Sunday’s federal elections in Germany are broadly in line with polls, showing the conservatives winning the election and becoming the largest party bloc in the newly elected parliament. A strong focus on the themes of inflation and immigration helped the far right party AfD score well with voters and secure second place behind the CDU/CSU. At the same time, the center right CDU/CSU has explicitly ruled out a coalition with the AfD, making its participation in government highly unlikely. With the center left SPD winning 152 seats, far more than the Greens, a coalition government between the CDU/CSU and SPD seems likely, as they have enough seats for a narrow majority in the new parliament. We breakdown our four key takeaways on what this could mean for the economy.
1. A new government could resolve structural issues
The German economy is suffering from a number of structural problems, as well as cyclical headwinds, such as a significant increase in labour costs. A new conservative-led government would have the chance to address at least some of the structural issues (e.g. boosting public investment by relaxing current debt rules) given its fiscally orthodox stance, which should prevent voters from being suspicious of fiscal policy turning into profligacy.
2. Abolishing debt will be challenging
At the same time, abolishing or reforming the constitutional debt brake will be challenging, since a ruling CDU/CSU-SPD coalition would need to win over both the Greens and the Left for such an endeavour, which requires a two-thirds parliamentary majority, and it is opposed by the AfD. We see a good chance that a new government will have a low threshold for suspending debt rules in order to increase investments in infrastructure and defence, where negative net investment risks could lead to a contraction in the capital stock. The role of political change in stimulating the economy could easily prove underwhelming, and we do not expect a return to economic growth until 2026.
3. Yields could go higher as a result of increased government spending
Attention has shifted towards the European bond market’s response to the prospect of increased government spending needs in Germany, specifically on the military side, as was demanded by the US administration. It is generally assumed that the shift in the German political landscape, as well as its associated change in leadership following the election over the weekend, should be more suitable for such an endeavour.
Moreover, some hope has also built up that Germany will make more use of the fiscal lever in order to get out of the economic slump that started to take shape already back in 2022. As a result, we have seen an increase in German government yields this month and a steepening of the yield curve, i.e. longer-term interest rates have risen relative to shorter-term rates, lifting EUR yields across the spectrum. Moreover, corporate credit spreads of European issuers have tightened, reflecting increased confidence among investors.
4. New opportunities with new fiscal headroom
The political change does open up some opportunities, and there is no doubt, in our view, that Germany has the necessary fiscal headroom. Nevertheless, we should not expect the new lawmakers to just open the fiscal gates at any price and to any extent. It will not be very straightforward to easily scrap the debt brake, the so called ‘Schuldenbremse’, given the distribution of seats. It is also likely that we will see other measures to guarantee more defence spending and potentially increased infrastructure spending. Thus, while there is some justification for higher yields and tighter credit spreads, we do not expect the dynamics to last much longer.
What does this mean for investors?
Following the German elections over the weekend, the new leadership change was confirmed. Since markets have already anticipated this result for some time now, we have ticked the box. The German self-help story may require some more patience now, but we think the new government will be up and running before Easter and that sizeable policy shifts will come out before the summer break.
Overall, we still feel comfortable with adding EUR duration to portfolios and see no reason to load up on EUR credit risk or to sell eurozone sovereign periphery debt.