It has been a hectic year for European politics. Hot on the heels of Brexit, President Trump’s victory and the Italian referendum last year, the 2017 electoral calendar has been packed with crucial votes for major European economies. The Netherlands, France and (following an unexpected General Election) the UK have all gone to the polls. We now look forward to the final key vote of the year, German Federal Elections.
The way politics were moving last year, it seemed that the spread of populism was increasingly taking hold. However, the respective failures of Geert Wilders in The Netherlands and Marine Le Pen in France appear to have allayed many of those fears. As we approach the final election of the year, the door is wide open for Angela Merkel to continue as Chancellor and add to her twelve years already in the post.
We consider the various issues surrounding the German Federal Elections will be held on 24th September. Who is likely to win and how will the result impact on the formation of the German government? How are financial markets preparing for the result and could there be an intriguing impact on the Brexit process?
How do the German Federal elections work?
In Germany, the Bundestag election is run under a system of “personalised proportional representation”. This means that the electorate casts two votes, one for a representative from their local district and another for a national party. The winning candidate from the 299 local districts (under first past the post) serve in the parliament as “direct mandates”. There are then a further 299 members elected under the national vote, allocated from a pre-described list of candidates via proportional representation. There is also a potential for “overhang seats” if a party’s direct mandates are in excess of its national vote.
Since 1990 there have been six parties represented in the Bundestag (counting the CDS and CSU as one party). Once all members are in place, a secret ballot selects the head of the government, known as the “Chancellor”.
Following the end of World War II and the end of the Nazi regime, German voters have returned coalition governments in every election, other than 1957. Unlike in the UK, the German electorate is comfortable with the politics of coalition. In Germany there is a fear for the repeat of the political conditions that allowed the Nazi Party to proliferate. Coalitions help to prevent any single party having overall control and are seen as helping to provide stability to the system.
Who is likely to win?
The polls have been moving in favour of Angela Merkel for several months now. As things stand in the run up to the election, it would be a complete shock if Merkel’s conservative centre right Christian Democratic Union (CDU) and sister party Christian Social Union (CSU) party were not to be largest party in the Bundestag.
The problem for the left-leaning Social Democratic Party (SPD) is that there is too little to differentiate in policies on the major issues between SPD leader Martin Shultz, and Angela Merkel. Shultz is simply not seen as enough of an alternative. He had an initial bump in popularity as he became the SPD candidate in January, but Merkel has pulled away decisively since then. It seems as though, the junior partner in the “Grand Coalition” is being punished. Shultz was unable to inflict any decisive blows on Merkel during the only live leaders debate and unless something drastic now happens in the final weeks of the campaign, Merkel seems to be fairly solid in her path to another victory.
One interesting dynamic of the election (which proved to be incredibly important for the UK election in June) could be the youth vote. There are an estimated three million first time voters, and in 2015, amongst the 18 to 24s demographic, the CDU took the most votes. Merkel is seen as “Mutti” (translates as “grandmother”) to many young Germans who have grown up with her being chancellor for the past twelve years. She is seen as being liberal-minded with her welcome for refugees in 2015 and having pushed through same-sex marriage as recently as June. Also, if anything, the election of Donald Trump in the US has firmed support for her amongst the young voters. A Forsa poll from June showed 57% of 18 to 21 year olds supported Merkel as chancellor which was higher than the 53% support for her across all voters. Compared with this, Martin Shultz is floundering amongst the young voters, a demographic that should naturally be cure CSU support, with just 21% favouring him as chancellor. If Merkel’s CDU/CSU can improve amongst the 18-24s from the 32% share of 2013, then the likelihood is that this would be a major step towards being the largest party in the election.
Populism is on the wane across Europe. With the defeats of Geert Wilders in The Netherlands, and Marine Le Pen in France, support for the Alternative for Deutschland (AfD) party has been falling away in 2017. From 13% at the turn of the year, its polling has dropped back to average around 9% in the final weeks of the campaign. From being clearly the third placed party in the polls just nine months ago, this retreat has put it back in the ranks of the minor parties that are massed now under 10%. Being the Eurosceptic, far right option for voters, being fiercely critical of Merkel’s stance on refugees there is no chance of the AfD taking part of any coalition.
What are the polls saying?
The polls tightened early in 2017 in the wake of Martin Shultz becoming leader of the SPD, However, gradually in recent months, the gap has widened once more and it looks as though Angela Merkel’s CDU/CSU will comfortably be the largest party. The gap is now around 15% with the CDU/CSU on course for around 37% to 40% of the vote.
This has come as the immigration issue has moved out of the spotlight and Merkel’s strength on the international stage has come back to the fore. Perhaps the leaders debate was the final opportunity for Martin Shultz to make a real impression but once more he struggled to differentiate himself from Merkel, failing to land any telling blows. With topics such as Donald Trump and Erdogan of Turkey discussed, Merkel was allowed to reiterate her undoubted image as the capable international leader.
The latest polls show a clear lead for the CDU with the SPD trailing by 15 points in second. Then there is a clutch of the four minor parties around 8%/9% that should also all get into the Bundestag above the 5% threshold.
If the polls are reflected in the election, the biggest inference from that is that Merkel’s party would then have several options for potential coalition partners. However, the most likely would be one of two options, another “Grand Coalition”, or the “Jamaica Coalition”.
1) A repeat of the Grand Coalition with the SPD. This would continue the government that has been in power for the past four years. However, the SPD would then have a big decision to make. They have struggled to differentiate from the CDU in this campaign and have seemingly suffered in the polls as a result. Some commentators and politicians believe the SPD would be best served by not being part of a Grand Coalition, instead forming the opposition from which they could then launch their campaign in the 2021 election with a clean slate.
Source: The Economist
2) The only really viable alternative is likely to be the “Jamaica Coalition” (referring to the parties’ colours, black of the CDU/CSU, green of the Greens and yellow of the Free Democratic Party). This is a realistic possibility, and a coalition between the CDU/CSU and the FDP would be likely Merkel’s preference. However this would depend upon a significant recovery of popularity of the FDP which dived below the 5% threshold in a dreadful 2013 election performance.
Source: The Economist
According to the current opinion polls, none of the other combinations that are likely will allow a Government to form with over 50% of the members. A left-leaning coalition (referred to as the Red-Red-Green coalition) is not expected to have the numbers on current polling. The SPD would need well over 30% and then hope for double figures from both Die Linke (The Left) and the Greens. Even if this were to be the case, could the SPD realistically command authority if the CDU/CSU are still the winning party?
Source: The Economist
Coalitions and the Impact on the Eurozone
The make-up of the Cabinet could be the only real variable and this could be the main theme for markets to watch. The two most likely would be a Grand Coalition or a Jamaica coalition. However, within those options, the exercise of power much depends upon the share of the vote.
Merkel would certainly prefer to go into coalition with the Free Democratic Party (FDP). However, the larger the share of the vote for the FDP, the more power it will have in the coalition. Perhaps over 10% of the vote may mean the FDP would be able to push for its prized goal, control of the finance ministry. It would then be able to push for corporation tax cuts and also less integration with Europe. With net tax relief, this would be a more business friendly and growth orientated course.
Alternatively, the CDU cold go down a very different path in its coalition partner. A repeat of the “Grand Coalition” with the SPD would not necessarily mean more of the same. SPD leader Martin Shultz has suggested his party has been too timid in the previous grand-coalition and he would push for more debate within the government. The SPD would push for increased welfare and infrastructural spending in Germany, whilst also pushing for much further European integration, with a potential push for a common European finance minister in addition to economic and monetary union (EMU).
A “Grand Coalition” could have significant repercussions for the Eurozone. Increased Eurozone integration could, by definition, mean that Germany subsequently steps back from its role as de facto head of the Eurozone. This could mean that Germany becomes less stringent on the economic restraints that some countries of southern Europe have felt so constrained by in recent years.
The better the CDU does in the share of the vote, the more likely it is that Merkel will be able to retain control of both the Chancellor and also the finance ministry. In this scenario, it would seem that the incumbent finance minister, Wolfgang Schauble, could well continue. Schauble has been a supporter of a tougher stance on economic credibility across the Eurozone, which critics have argued have exacerbated high unemployment and low growth in the region.
The Impact on Brexit and the UK
Brexit seems to be far more of an importance to the UK than it is in Germany. In fact, Brexit has barely been an issue in the electoral campaign. All of the main parties are pro-EU but attitudes to the union do slightly vary. The SPD and Green parties would like a more federalist approach and favour deeper integration especially within the Eurozone. Merkel’s CDU/CSU and the Free Democrats are less keen on further integration, instead favouring a more inter-governmental approach.
However with Merkel looking odds on to remain Chancellor for the next four years, she will be integral to the German approach to Brexit. So, what does Merkel favour? Angela Merkel takes a pragmatic stance to Brexit and is probably the best option for Britain. She believes that there should be no punishment for Britain, and that a good relationship for the future is important. However, she also does not favour any cherry-picking over Single Market access for the British.
Merkel’s stance is predictably similar to that of the CDU/CSU, whose manifesto notes that countries leaving the EU (i.e. the UK) cannot enjoy the same benefits of the remaining EU members (EU-27). With the CDU/CSU likely to form part of a coalition government, what would its partners want for Brexit?
One thing to note on the stance of coalition partners, is that coalition building is achieved through negotiation. Would the junior parties look to use up valuable political capital on Brexit when the positions of other major parties are largely all similar? Their focus is likely to be elsewhere, meaning the views of the CDU/CSU are likely to be taken forward for Germany’s stance on Brexit negotiations.
Furthermore, much to the chagrin of the UK negotiators, Germany will not be a soft touch for a good deal. With “integrity” of the EU-27 a recurring theme through parties’ election manifestos, it is highly unlikely that Germany will break ranks and dominate the negotiations. It is not in Germany’s interests to jeopardise the appeal of the EU amongst its members by bullying its will over Brexit. Subsequently, there will be no Brexit deal “made in Berlin” as David Davis, the UK’s Brexit Minister, has previously hoped.
The Impact on Bund yields and the euro
Markets have been fairly settled for several months on the fact that Angela Merkel is likely to be the Chancellor after the election. Bund yields have been falling in recent weeks, but there is a consistent theme across government debt of the majors. With economies collectively struggling to generate inflation and latterly a safe haven flow due to increased geopolitical tensions from North Korea have driven yields lower.
However German Bunds are showing little evidence of outperforming (i.e. yields falling at a faster rate) versus other core yields. The chart below shows how the yield spreads have been falling throughout 2017 on German Bunds versus Treasuries, French OATs and UK Gilts.
Despite this, the Bund is still a safe haven play and any result in the election that lead to any degree of uncertainty will lead to Bund yields dropping. This would be seen in any scenario that results in no clear result or a protracted period of “horse-trading” between the political parties in search of a coalition.
The chart below shows that since November 2016 there has been a strong correlation between the moves on the 10 year Bund/Treasury spread and EUR/USD. The graph has the spread inverted, meaning that the chart moves higher as the spread tightens, so that as the spread tightens the chart moves higher. This would either be through the Bund yield rising faster than US Treasury yield, or the Bund yield falling slower than the Treasury yield. Given that yield differentials between the Bund and Treasuries are a key driver of the euro, a falling Bund yield would likely pull the euro lower.
The Impact on the DAX
There are two aspects in which the election could impact on German equities. First of all, the configuration that the coalition takes, but also the second round impact that the euro and Bund yields will have on the DAX.
Primarily, German equities would be looking for a pro-growth, market-friendly outcome from the election. This would best be served through a CDU/CSU coalition with the Free Democrats. The FDP favours lower taxation and markets with less regulation. Furthermore, if the FDP performs well in the election they may also be able to win control of the Finance Ministry. This would be the platform for them to generate the most influence on the coalition. This would be a positive outcome for key sectors in the DAX such as Industrials (12%), Technology (11%), Basic Materials (15%) but also Financials (15%) which collectively account for more than half the weighting in the DAX.
An SPD victory would be unexpected and would be DAX negative. This would be especially the case if they chose not to go into a grand coalition with the CDU. If they could garner enough support from the left-leaning parties in the Bundestag, they would prefer to go for a “Red-Red-Green” coalition. However, the higher taxation and increased regulation that would be inferred by a socialist government would be less business friendly and be negative for the DAX.
The impact of the euro will also be key. This would be due to the high proportion of overseas revenue generated by the huge exporters in the DAX which drives a negative correlation between the performance of the DAX and the euro. For example, luxury car giant, BMW derives around 87% of sales from outside Germany, whilst engineering conglomerate Siemens generates 85% of revenue from overseas. The strength of the euro can be negative for the revenues of the big German multi-national companies. Once overseas revenue is translated back into euros the top line takes a negative hit from a stronger euro. Since mid-June, the euro has strengthened by 7% against the US dollar, a time during which the DAX has fallen by 5%. The direction of the euro has an impact on the DAX.
As can be seen in the chart, for much of the past year, the performance of the euro has been negatively correlated to the DAX. There have only been a period of a few weeks (in January and March) where the correlation seemed to break down, whilst only during May did the correlation become seriously positive as both the euro and Eurozone equities benefitted from Macron’s push for victory in the French Presidential election. However, as the initial exuberance of the French election dissipated into June, the euro and the DAX have since resumed their negative correlation.
Although there are key aspects to consider outside of politics (specifically the potential taper of ECB asset purchases), any result in the German election that drives euro volatility and direction is also likely to impact the DAX with a negative correlation.
The impact on other markets
With the result of the German election highly likely to return Chancellor Merkel into power, the prospect of a surprise result is somewhat low. The euro-sceptic AfD party is polling in single figures whilst all of the main parties in Germany support the Eurozone in some shape or form. So, unlike in The Netherlands or France, there is no realistic chance of an anti-EU party winning power, or even gaining political influence. Other parties will not even entertain the possibility of a coalition with the far-right AfD. Therefore, the prospects of a sudden safe haven flow on a surprise result that could significantly shake up the political system in Germany (and subsequently the Eurozone) are low.
With markets settled in their expectation of a Merkel victory and the German election low down on the list of investor concerns, safe haven trades such as gold or the Japanese yen are unlikely to be significantly impacted.