On Sunday 25th September Germany will go to the polls. Chancellor Angela Merkel is widely expected to win her fourth term in power, Oddschecker has Merkel’s victory at a 97% probability. The latest polls put her CDU party at 28%, with the opposition Social Democrats at 23%. While Merkel’s party is not likely to win an outright majority on Sunday, German governments have tended to be coalitions since the Second World War.
Why a German political shock is highly unlikely
The coalition issue is a key one for investors as it’s the main reason why we are confident that the polls are correct and Merkel will be the next Chancellor. This is an important point for investors’, in recent elections the polls have been wrong and the underdog has won turning the political status quo on its head and triggering a spike in volatility. We don’t think that the same political shock will come from Germany for two reasons.
- Firstly, due to the coalition government in Germany this election is not a binary outcome unlike the Trump vs. Hillary election in the US last November. The SPD opposition can, realistically, get into power but only with a coalition with the CDU with Merkel as leader.
- Secondly, Merkel’s popular support is extremely high, with more than 60% of those polled saying that they would want Merkel as leader, which suggests her fourth Chancellorship has cross-party support.
Coalition options after the election:
- The Jamaican coalition with the CDU/ FDP and Greens: A coalition with the FDP – the business-friendly party – could be good news for the German corporates as it may help spur lower tax rates and business-friendly policies. However, there are some downsides to this, including the need to bring in another party to get enough to seats to win, most likely the greens, who could struggle to get along with the FDP. Also, the FDP tends to be anti-EU, which could spook investors at first, although we think that Merkel could keep their anti-euro tendencies under control. Three party coalitions tend to be rare in Germany.
- CDU and SPD Grand Coalition: this would be the cleanest outcome from the election as it would easily give Merkel the percentage of votes that she needs to lead the country, although it may not be the coalition that she would choose. A grand coalition would probably mean a bigger role for her SPD rival Martin Shultz, which may not be appealing to Merkel, so we wouldn’t be surprised if she pushes, at least at first, for the Jamaica coalition.
- AfD – no chance of getting into power: The anti-EU/ anti-immigration/ Far Right party is expected to get approx. 9% of the vote, however, all of the main parties have ruled out joining a coalition with them, which leaves them as a spent political force. However, just because they can’t get into power does not mean that the AfD is not dangerous, and if they poll better than expected then their influence could still be felt. We believe that a showing of 12% or more in Sunday’s polls would be considered a good result for the AfD.
The financial market response:
Interestingly, there are good reasons to suggest that either the “Jamaica” coalition or the Grand coalition will be good news for German asset prices, which is one reason why the Dax is rallying this week ahead of Sunday’s vote.
As we mentioned, a deal between the CDU/ FDP/Greens could be seen as pro-business, with the FDP potentially securing corporate tax cuts as the price to support Merkel in this three-way coalition. This is, unsurprisingly, good news for German business and thus the Dax. Equities that could be boosted by a “Jamaica” coalition include:
- Deutsche Bank
- Carmakers: Volkswagen, Daimler and BMW – the FDP may press for more relaxed legislation even with the Greens on board.
The CDU/ SPD grand coalition may also be good news for German stock prices as the SPD may put pressure on Merkel to loosen the purse strings and boost public spending on infrastructure in her fourth term as Chancellor. This could boost the engineering and metal big hitters on the Dax in the aftermath of the coalition being announced, including:
- Thyssen Krupp
- Heraeus Holdings
The Dax is likely to be sensitive to the outcome of the German election and we believe that there is the potential for further strength as long as 1, Merkel wins, 2, the AfD don’t win more than 12% of the vote.
However, we also note that the Dax is influenced by multiple factors including the strength of the euro. In fact, the chart below shows that it is the euro, rather than Merkel that matters more for the German stock index. This suggests that even if Merkel is reinstated as Chancellor, as expected, if the euro rises sharply then the Dax may be more sensitive to the rising currency and its impact on exporters than it is to domestic politics. This is due to the inverse correlation between the Dax and the euro, so when the euro rises the Dax tends to fall, as you can see in the chart below.
The 1-week EUR/USD At-the-Money option volatility is currently at 9.3% with 5 days’ to go before the vote, which is actually a touch less than the Vix at 9.95%. Although this level has been rising since July, it remains incredibly low and is far lower than it was ahead of the first round of the French election in April when it surged to 18.66. This suggests that FX traders are sanguine that the German election will not throw up a surprise that could trigger a sharp move in the euro. So, if Merkel’s CDU wins approx. 36% of the vote as expected, then we do not expect any outsize moves in the euro at this stage, although we would expect the single currency to drift higher at the start of next week upon confirmation that Merkel has secured a fourth term as Chancellor.
German Election Strategy: the Dax vs. the FTSE MIB
Our one to watch this German election is a relative value trade between the Dax and the Italian FTSE MIB. The Italian index has outperformed the German and overall European index since March this year, although its performance really took off over the summer, as you can see in the chart below. However, we believe that with the German election out of the way political risk in Italy, which needs to hold an election by Q1 2018, may start to rise which could weigh on the Italian index. Also, after strong gains in recent months, the Italian index is looking less attractive from a valuation stand point, which may also support the Dax to outperform in the coming months.
German equities: could get a boost once the next German coalition government is confirmed.
The Dax: could benefit from a win for Merkel, and we expect it to outperform the FTSE MIB in the coming months, although it remains sensitive to euro strength.
The euro: nothing in the market is telling us to expect a big move in the euro on the back of an expected win for Merkel’s CDU party this weekend. With EUR/USD hovering around $1.20, the highest level since early 2015, this is unsurprising.