Europe’s largest economy, Germany, was plunged into chaos last week, with the collapse of the ruling coalition. With a snap election set to take place early next year, Kaspar Hense, Senior Portfolio Manager, gives his views on the political backdrop and what it means for portfolio positioning.
Key points:
In the piece, Kaspar Hense discusses:
The political backdrop in Germany.
The upcoming election and formation of a coalition next year.
Proposed EU budget solutions and fiscal union.
The implications for portfolio positioning.
Looking into next year, chancellor Olaf Scholz will no longer be in the ‘room where it happens’. His policies have been too restrained, and he hasn’t been able to make a mark, either on the debt ceiling or Ukraine. It has certainly been one of the most difficult times in Germany’s post-war history. The economic impact of Covid (the most severe global pandemic since the Spanish flu), China's aggressive export strategy (which has outstripped German competitors, especially with regard to electric vehicles), Russia’s attack on Ukraine, and the European energy market were not supported fiscally. This is due to the schwarze Null or “black zero” – a commitment to balanced budgets. One could almost consider this as a success if an end to the trouble was foreseeable. However, the ongoing geopolitical threat from Russia, the total lead of China’s industrial sector, and US digital dominance require more investment than the current coalition has been able to deliver. The formation of a new coalition will be difficult. The populist parties on the right and left are set to get almost one-third of all votes and could possibly block decisions that require an absolute majority, such as a change of the “black zero” policy. Moreover, the Christian Democrats are likely to need two coalition partners for a majority government. The hope, from German opposition leader Merz's point of view, would probably be for a ‘Jamaica coalition’ – a term describing a governing coalition among the parties of the Christian Democratic Union/Christian Social Union, Free Democratic Party, and the Green Party – as opposed to a coalition with the SPD. However here, too, the major differences in policy between the Greens and the Liberals would have to be bridged. The question is: how can Merz solve the Gordian knot of investing more, especially in the military, without increasing other spending and without losing even more tax revenue in an environment of potentially rising unemployment rates? The election programme is clear and aims to increase productivity through lower social spending. However, that isn’t likely to be enough. What Merz wants, and what would be a possible solution, would be the European way. It would be an expansion of military spending but it would require this spending not only with European partners, but also financed by the EU, to solve the puzzle. The EU’s seven-year budget is due in summer, with Germany set to be the only substantial net contributor. What if payments were reduced but they financed common military expenditure across the EU? It would be the beginning of a European fiscal union, which would no longer be reversible, and with high productivity potential in the long term. The required 2% of NATO would be at a level of approximately EUR300 billion, without taking into account national expenditures¹. For Germany, it would clear the way for a growth package of EUR100 billion for further expansion of energy infrastructure and necessary spending on digital transformation. This would also minimise dependency on the US. Added to this would potentially be the EUR20 billion that Germany is paying into the EU pot, if Poland could also finance its military spending through the EU². Poland is the largest nominal net beneficiary of the EU budget. A grand coalition might also be possible, which would “play around the edges” of the debt limit. This wouldn’t be in the interest of the SPD (which could regain voters better in the opposition), nor would the compromise that would emerge from this coalition be satisfactory. Merz will have to decide on the lesser of two evils; either take on more debt or seal the European integration to finally to prepare for the future. That would be his legacy. For now, we are short the euro and our long duration bias with Europe will continue to be under pressure. This is especially with regards to the looming trade war, where Europe will be sitting between a rock (the US) and a hard place (China) and will suffer potentially the most. We are also fearful of an upcoming forced peace deal which might not support stability in the region. We remain short the Baltics but like Romania which should be supported by infrastructure investments thereafter. The only reason to be positive Europe right now would be a change to more European investments. It remains to be seen if Merz will do what is needed.
¹ RBC GAM.
² Spending and revenue - European Commission.
