As of Monday’s close, Germany’s benchmark DAX index rose 1.26%, marking a new record high for the sixth consecutive week since the start of the year. With a year-to-date increase of over 13%, investors in the neighbouring U.S. stock market have taken notice.
Are Investors Ignoring Election Risks?
Despite the looming German general election next week, market participants appear unfazed. Optimism surrounding the potential formation of a pro-business governing coalition and expectations of fiscal policy relaxation seem to outweigh concerns about election uncertainty.
For context, last year’s European Parliament elections led to significant political turmoil in France, negatively impacting French assets. The French CAC 40 index remained on a downward trend for more than six months, only rebounding toward the end of the year.
Daniel Murray, Deputy Chief Investment Officer at EFG Asset Management in Europe, highlighted a key risk: election results may not be as market-friendly as expected. Recent elections have demonstrated increasing unpredictability, making the market’s confidence seem premature.
Markets Hope for Fiscal Expansion
Investors are optimistic that the upcoming election might pave the way for Germany to relax or abolish its constitutional “debt brake” restrictions, long championed by conservative politicians and fiscal hawks.
Friedrich Merz, the CDU candidate and a frontrunner for the next German Chancellor, has openly expressed his willingness to adjust these fiscal constraints. A CDU-SPD coalition government, potentially led by Merz and current Chancellor Olaf Scholz’s Social Democratic Party, is seen as the most favorable combination for fiscal expansion—potentially benefiting the stock market.
The Role of the Far-Right Alternative for Germany (AfD)
A major unknown factor in the election is the performance of the far-right Alternative for Germany (AfD) party. Over the past year, polls have consistently placed CDU’s support around 30%, while AfD has remained just above 20%, with SPD holding a stable third-place position.
Despite strong endorsements from former U.S. President Donald Trump and billionaire Elon Musk, as well as increasing concerns over immigration-related incidents in Germany, AfD’s polling numbers have not surged significantly. This raises questions about the accuracy of polling and whether external analysts have underestimated Germany’s political landscape.
Anekha Gupta, Head of Macroeconomic Research at British asset management firm WisdomTree, emphasized that while a simple majority is needed to form a government, a two-thirds majority is required to amend the constitution. If AfD performs strongly, the optimistic outlook on fiscal expansion could shift dramatically.
Lessons from the French Market Collapse
In mid-2024, French stocks tumbled over 10% after President Emmanuel Macron announced early elections, and it took eight months for the CAC 40 index to recover. Political instability made France one of the worst-performing stock markets in Europe last year.
Gupta warned that current market sentiment mirrors the French election scenario, where investors underestimated political risks, only to see them dictate the European stock market narrative for the latter half of the year.
The Greater the Hope, the Greater the Disappointment?
Investor optimism surrounding the German election has already been priced into the market. The swap spread between German 10-year and 30-year government bonds has reached historic lows, indicating strong expectations for increased government bond issuance.
A recent Bank of America survey found that Germany is now the most popular stock market in Europe, primarily due to expectations of fiscal stimulus.
However, with the DAX index entering “overbought” territory, some analysts caution that even in the absence of negative news, the market could be due for a correction.
Uncertain Future for Fiscal Reform
Opinions are divided on the future trajectory of German stocks. Some analysts argue that Germany’s export-driven economy and the strong presence of internationally focused technology companies in the DAX index make it less dependent on domestic politics. Additionally, the rise of artificial intelligence and global trade trends could have a greater influence on the index’s performance than election outcomes.
Others, however, caution that even if Merz secures the chancellorship, his fiscal reforms may not meet the market’s high expectations. Edward Cole, Head of Multi-Strategy Equities at Man Group, warned that excessive optimism could lead to disappointment, particularly if policy changes take longer than anticipated.
Following Merkel’s departure, Germany has struggled with prolonged coalition negotiations. After the 2021 election, it took Chancellor Scholz nearly two months to form the “traffic light” coalition government. Investors may wake up on February 24 to find that election results are less conclusive than expected, potentially delaying or even derailing the anticipated fiscal policy shifts.
Conclusion While the German stock market continues to hit record highs, the underlying political risks cannot be ignored. If history is any indication, markets may be underestimating the potential for post-election uncertainty. Investors should remain cautious, as high expectations for fiscal expansion could lead to significant volatility should the results fail to meet market optimism.
