German vote could open door to spending

Germany’s conservative CDU/CSU party has secured victory in the federal election, giving it the upper hand to start coalition talks. With the Greens short of seats, CDU/CSU’s only viable two-party coalition is with the center-left SPD, excluding the far-right AfD. Regional markets may welcome a coalition with enough support to push through policy changes. Market focus will likely now be on whether the new coalition moves to ease Germany’s constitutional 'debt brake’ that limits how much the federal government can borrow. CDU/CSU leader Friedrich Merz aims to have a coalition in place by Easter, but easing debt limits requires negotiation and a constitutional change. Germany’s central bank is set to propose changes to the debt brake in March or early April.

Right now, the government budget deficit must not exceed 0.35% of GDP. That’s far stricter than the 3% permitted under the European Union’s fiscal rules. A loosening of that rule could unleash more government investment and help stimulate the country’s tepid economic growth, we think. The conservatives are focused on boosting investment but may want cuts to social benefits and other government subsidies that the SPD might object to. The Greens will likely tie their support to decarbonization commitments. The far-left Die Linke, outperforming polls at 8.8% of the vote, will also be needed to reach the required two-thirds parliamentary majority – and could demand a high political price.

Friedrich Merz, likely the next chancellor, is expected to strengthen ties with French President Emmanuel Macron. That could bolster EU policymaking on U.S. trade tariffs, competitiveness, development of artificial intelligence and gaps in defense spending as the U.S. says Europe is no longer a primary security priority. Merz has floated central EU defense funding, though political hurdles remain. Alternatively, he may pursue a special domestic fund, though this would also require a two-thirds parliamentary majority.

Europe’s stocks have been outperforming U.S. peers this year – and are much cheaper on a relative basis than they’ve been for decades. With a lot of bad news already priced in, even prospects of good news could help them push higher. German fiscal stimulus may still be some way off, but regional markets will welcome political clarity. A de-escalation of the Ukraine war could lower energy prices and boost European growth. And the EU has an air of urgency now that typically spurs action: It is holding an extraordinary summit on defense next week. We expect more European Central Bank rate cuts this year: euro area growth is still sluggish and inflation has eased. We stick with our relative preference for euro area bonds over U.S. Treasuries, especially long-term bonds.

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