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Summary of European Economic Perspectives: German Election and Market Implications

Core Content Overview

Germany is set to hold snap parliamentary elections on 23 February 2025. This document provides an analysis of the potential economic and market implications based on macroeconomic scenarios, party manifestos, and opinion polls. It outlines the likely outcomes of the election, the impact on fiscal policy, and the effects on financial markets such as FX, rates, and equities.

Key Election Themes and Market Implications

• Election Outcome:

  • The CDU/CSU is currently leading opinion polls with 32%, followed by AfD (19%), SPD (16%), Greens (13%), and BSW (5%).
  • The liberal FDP is polling at 4%, potentially below the 5% threshold for parliamentary representation.
  • A new government is expected to be formed by the end of April at the earliest, based on historical averages of coalition formation times.

• Coalition Possibilities:

  • A "grand coalition" (CDU/CSU-SPD) or a "black-green" coalition (CDU/CSU-Greens) are the most likely options.
  • A two-third majority in parliament is necessary to reform the debt brake, which would allow for increased public spending.
  • Polls suggest that CDU/CSU, SPD, and Greens could control 72% of seats, making it unlikely for AfD or BSW to block fiscal reforms.

• Voter Concerns:

  • Economic concerns are the top issue for voters (34%), followed by immigration (23%).
  • Unemployment and wage/price issues are less prominent (5% and 9%, respectively), compared to the peak of inflation in 2022 (45%).

Fiscal Policy and Debt Brake Reform

• Common Fiscal Proposals:

  • All major parties support tax cuts for households, lower corporate taxes or investment subsidies, reduced energy charges, and lower bureaucracy.
  • Defence spending is committed to at least 2% of GDP, aligned with NATO targets.

• Debt Brake Reform:

  • A reform of the debt brake is expected, with potential fiscal easing of around 0.65–0.75% of GDP per year.
  • This would likely be used for defence and infrastructure spending, but not for consumption or welfare policies.
  • The SPD and Greens are in favor of reforming the debt brake to boost investment, while CDU/CSU leader Friedrich Merz expressed openness to reform under certain conditions.

• Fiscal Cost Estimates:

  • The estimated fiscal costs of proposed measures vary significantly across parties, ranging from 0.7% of GDP (SPD) to 3.2% of GDP (FDP).
  • A "Germany fund" is proposed by SPD and Greens to finance investment.

Macro Implications: Three Scenarios

1. Status Quo/Stalemate (25% probability):

   • No agreement on fiscal easing.
   • Weaker growth outlook than projected.
   • Limited impact on markets.

2. Modest Cyclical Lift (60% probability - Base Case):

   • Debt brake reform with increased public spending on defence and modest support for households and corporates.
   • Growth is expected to return to its potential level of 0.8% by 2026.
   • Structural headwinds remain.

3. Growth Boost (15% probability):

   • Substantially higher fiscal spending and structural reforms.
   • Could raise Germany's medium-term growth potential.

Equity, Rates, and FX Implications

• Equity Market:

  • Corporate tax cuts are the most important implication, with a potential 5% tax rate reduction adding 7% to corporate profits.
  • Limited fiscal stimulus is expected to have a negligible impact on German companies and broader European equities.
  • Specific sectors like defence and capital goods may benefit from c€30bn in additional spending.

• Rates Strategy:

  • The election is viewed as positive news for the safe-haven status of German government bonds (Bunds).

• FX Strategy:

  • A lasting impact on EUR is expected only in the case of a stalemate (EUR negative) or a growth boost (EUR positive).
  • Modest fiscal easing under the base case is unlikely to affect the EUR significantly.

Key Themes from Party Manifestos

Fiscal Easing Constraints

• EU Fiscal Rules:

  • Germany must comply with EU rules, including a 3% GDP deficit limit and a 60% debt/GDP limit.
  • The structural deficit safeguard is 1.5% of GDP, which limits the amount of fiscal easing.

• Debt Brake Reform Options:

  • Escape Clause: Can be triggered with a simple majority, but requires an amortization plan and is renewed annually.
  • Special Fund: A €100bn fund for defence or infrastructure, not subject to the debt brake.
  • Debt Brake Change: Lifting the structural deficit limit from 0.35% to 1% of GDP, potentially unlocking 0.65% of GDP in additional spending.

• Estimated Fiscal Space:

  • The additional fiscal space from debt brake reform is estimated to be 0.65–0.75% of GDP per year.
  • This is likely to be used for public investment, particularly in defence and infrastructure.

Conclusion

The German election is expected to result in a coalition government with potential fiscal reforms, especially regarding the debt brake. These reforms could lead to limited fiscal easing, which may have a modest impact on financial markets. The most significant market implications are likely to be in the equity sector, particularly for companies in defence and capital goods, due to potential tax cuts and increased public spending. The FX market may see EUR movements depending on the election outcome, with a growth boost scenario leading to EUR appreciation and a stalemate scenario leading to depreciation.