Please find below a new comment from Nadia Gharbi, Senior Economist, at Pictet Wealth Management, on the markets’ reactions to the German elections.
The election results in Germany have confirmed a notable shift to the right in the political landscape. The center-right CDU/CSU, under the leadership of Friedrich Merz, emerged victorious with 28.5% of the votes. While this is a significant improvement from their previous performance, it remains the second-worst outcome for the party since World War II. The far-right Alternative for Germany (AfD) achieved its highest-ever vote share, securing 20.8% of the votes, which is double their 2021 result. The center-left SPD came in third with 16.4%, one of their worst results in history. The Greens received 11.6% of the votes, while the left wing The Left, which saw a surge in recent weeks, garnered 8.9%. The left-wing BSW narrowly missed the 5% threshold needed to secure seats in the Bundestag, with 4.9%. The center-right FDP also fell short, dropping out of parliament with only 4.3%.
Compared to pre-election polls, the CDU/CSU performed slightly worse than expected, and the SPD did marginally better. The Left outperformed expectations. Of note, voter participation was notably high, with turnout reaching 84%, the highest level since German reunification in 1990.
A two-party coalition with the CDU/CSU and the SPD is the most likely outcome
Despite the mathematical possibility, the CDU/CSU has categorically ruled out forming an alliance with the far-right AfD. The most likely outcome is a so-called grand coalition between the two largest parties, the CDU/CSU and the SPD. This type of coalition has been formed four times since World War II, including three times under Angela Merkel's leadership. However, it’s important to note that Friedrich Merz, the current leader of the CDU/CSU, has shifted the party further to the right, adopting a tougher stance on migration. Despite recording one of the biggest losses in the election, the SPD holds a very strong bargaining position in coalition negotiations. Coalition talks are likely to take weeks if not months. Friedrich Merz, the leader of the CDU/CSU, would like to wrap up coalition negotiations by Easter (20 April). If so, the new government could take office shortly afterwards. Defense, migration and tax policy will probably be the main topics in coalition talks.
If coalition talks do not result in a stable majority, Germany could see the formation of a minority government. This would be unprecedented at the federal level, as Germany has never had a minority government. Another possibility if coalition negotiations fail is the calling of snap elections.
Modest fiscal expansion possible, but complex
Centrist parties failed to achieve a constitutional majority, with the three parties CDU/CSU, SPD, and the Greens jointly holding under 66% of the seats. This means that any constitutional changes, including those related to the debt brake, Germany’s fiscal rule, and the setup of an off-budget fund, would rely on the support of either the Left or the AfD, two populist parties. This situation will complicate discussions about fiscal policy.
The Left and the AfD have little in common. The AfD is committed to maintaining the debt brake, while the Left is open to reforming it and supports more infrastructure spending but opposes new military spending. In the absence of a constitutional change, the grand coalition could invoke the escape clause of the debt brake. Germany’s constitution allows for this with a simple Bundestag majority in “emergency situations”. This mechanism was used by the government to address the Covid pandemic and the energy shock between 2020 and 2023. Overall, discussions are likely to take time, but we believe that a modest fiscal expansion is possible, albeit complex. It is also possible that domestic obstacles could mean that Germany may be more open to EU-funded initiatives, especially on defense.
