(Bloomberg) -- Europe’s equity markets are priced for a near-perfect outcome from the high-stakes German federal election. For some investors, that raises the risk of a nasty surprise.
Germany’s benchmark DAX Index as well as the pan-European Stoxx 600 have notched record after record this year, partly on optimism that Germany’s new government would carry a robust voting majority in parliament, allowing it to push through much-needed reforms and kick-start the economy.
But if history is any guide, betting on a sure-shot outcome from the Feb. 23 vote — or underestimating the risk of potential market turmoil — could prove to be shortsighted. In 2024, the European Parliament election unexpectedly led to the French government being toppled and triggered a selloff in domestic assets.
“There is a clear risk that the outcome isn’t as market friendly as is currently expected,” said Daniel Murray, deputy chief investment officer at EFG Asset Management. “If there’s anything we’ve learned with regard to election outcomes, it’s that they’ve become much less predictable.”
For investors, the election has spurred optimism that the nation may loosen its strict borrowing rules — the so-called debt brake — that have long been championed by conservative politicians and fiscally hawkish economists.
Friedrich Merz, the Christian Democrat chancellor candidate who leads in opinion polls, has signaled openness to tweaking the mechanism but cautioned Germany must first slash bureaucracy and expenses before discussing more debt. A coalition between his CDU/CSU alliance and Social Democrats or the Greens — who are also proponents of increased borrowing — is viewed as the most market-friendly outcome.
The bullish narrative is complicated by the strong poll numbers for the anti-immigrant Alternative for Germany party. A fair amount of inter-party collaboration will be needed to keep the far-right group isolated in parliament and prevent it from gaining influence on political decision-making.
Given the convoluted process that might be needed to form a government — it took two months after the 2021 election — investors could wake up on Feb. 24 to the prospect of a long stretch of wrangling. And even once a government is in place, there may not be the necessary backing to change the Constitution and loosen the debt brake.
While it takes only a simple majority of Bundestag seats to elect the government, a two-thirds majority is needed in both houses of parliament for constitutional change, said Aneeka Gupta, director of macro-economic research at Wisdomtree UK Ltd.
“It could be the big catalyst for stocks and it could hugely benefit the German economy,” she said, but a strong showing for the AfD “could change that optimistic scenario.”
A majority of institutional investors in a Morgan Stanley survey said they expect an overhaul of the country’s strict borrowing limits, although about 46% warned of the possibility of a minority result that would prevent fiscal expansion. Polling also shows a majority of German voters support such a move.
Scaling Peaks
Germany’s large-cap DAX Index has been an outperformer with a rally of 76% since its post-pandemic low in late 2022, driven by gains in software company SAP SE and a robust global economy that has boosted its export-oriented constituents. The gauge widened that lead after German Chancellor Olaf Scholz called the surprise election in November.
A survey by Bank of America Corp. last month found Germany had become the most preferred equity market in Europe as investors counted on a boost from fiscal stimulus.
Germany has long enjoyed the cheapest borrowing costs in the euro area, given its commitment to austerity and keeping a limit on the amount of debt it issues. For those reasons, investors say that — unlike many other developed nations — it has the capacity to issue more bonds to boost investment spending.
There are signs that investors have already priced in some increase in bond issuance. German 10- and 30-year bunds are around the cheapest relative to same-maturity interest-rate swaps on record, a gauge known as the swap spread.
The widespread optimism means any idiosyncratic shock could result in a selloff in stocks. The gains are already looking overheated by a standard measure of price momentum: The relative strength index shows the DAX in so-called overbought territory — a level considered by some investors as a precursor to a selloff.
In mid-2024, France’s CAC 40 Index sank more than 10% after President Emmanuel Macron called a snap election. It took the index eight months to finally claw back those declines, and it remains among the worst performers in Europe over the past year. The political turmoil also contributed to the Stoxx 600 suffering one of its worst years relative to the S&P 500.
“The risk in the market is very similar to what happened last year where everybody was underpricing that event and it actually literally paved the way for the European equity story in the second half of 2024,” Gupta said.
Export Cushion
Some market participants argue German stocks are more insulated from election risks.
Max Kettner, chief multi-asset strategist at HSBC Holdings Plc, said the DAX has a large weighting in international and technology-related companies, and they “have little to do with domestic fundamentals, nor with the political outlook for Germany. It’s much more about the broadening artificial intelligence trade.”
Some investors, though, said even a Merz-led victory may not spark further rallies in financial markets, as any fiscal reform is likely to be too timid to have much of an impact on growth.
“There’s now quite a strong consensus around the Merz-led government and the DAX has done extremely well,” said Edward Cole, head of multi-strategy equities at Man Group. “Even if Merz leads the next government, there could just be disappointment about how long it takes to do.”
--With assistance from Alice Gledhill and Christoph Rauwald.
