German elections a snoozefest but watch yields

Chancellor Angela Merkel and the CDU are almost guaranteed to remain Germany’s dominant political forces after Sunday’s elections, but it would be a mistake to underestimate the importance of the vote for European markets in the years ahead.

Tell-tale yields

Barring another anti-establishment shock of the kind seen over the last two years, the probability of which is greatly reduced by Germany's political system, Sunday night's results are indeed unlikely to bring a great deal of volatility. But it would be inaccurate to characterize the attitude of large investors to the vote as academic. Institutional market participants across asset classes see Sunday's vote as a critical event for the wider European economic and political landscape, with direct consequences for flows, valuations, risk and returns for years to come.

The most obvious factor at stake is the Eurozone’s resounding return to growth that became unequivocal this year, underscored on Friday by strong PMI readings across France, Germany and the next most active regional economies. But whilst GDP readings have met forecasts and inflation has made a slow grinding return, benchmark 10-year bund yields remain below 1%, suggesting real money has not ventured too far from safety. The exact exponent of the rebound is in focus, and uncertainty about the nature of the coalition is an important fulcrum.

Franco-German axis

Further Eurozone integration depends on the colour of that coalition, with the Franco-German axis being the conduit for possible structural and governance changes. France now has one of its most committed presidents to the European project for decades in Emmanuel Macron, but his programme of reform at home and implicitly for the bloc, will make little progress without Germany on board. At the same time, Merkel is likely to baulk at some aspects of the integrationist agenda, like a separate Eurozone-wide budget and fiscal union, which Macron favours. Before ever closer union, a tussle for the tacit role of Europe’s political leadership may ensue.

Considering that the business-friendly, fiscally conservative and centrist FDP lags the far-right Afd party, chances of Merkel’s ideal coalition occurring look slim, seemingly inching  forward the case for a pairing with the SPD—the next strongest polling party after the CDU/CSU. Led by former European Parliament President Martin Schulz, the SPD’s star has faded, but it is still politically the strongest supporter of the most progressive pro-EU policies in the region.

Merkel-Schulz axis

If Merkel calls the Schulz’s bluff and the SPD chooses to become the opposition, she is less likely to have enough votes with the FDP alone and may have to allow the Greens on board. This will introduce wider ideological differences between the three, but would not negate a tendency to be forced on board the Macron train. Before that of course, the risk of a longer-than-expected delay for the formation of a coalition would be higher, bringing the first direct risky consequences from the federal elections for stock markets.

Compression pressure

In short, we see a rising probability of deeper Eurozone integration going forward, and that includes moves towards fiscal union. In turn, that implies further bond spread compression between the benchmark and peripheral yields. Under those circumstances, the only way would be up for German bund yields, particularly if momentum takes over as the opportunity for institutional investors to profit from the compression trade becomes more compelling. Bear in mind however that whilst inexorable, the process of convergence has been a long one, as illustrated below.

Another euro boost

As we have seen though for the euro, with respect to the ECB’s tapering preparations, even an implied knock-on effect from rising bund yields can suffice to buoy it. Higher bund yields generally imply further range expansion to the upside for the euro of the kind which has challenged major Eurozone equities and indices this year.

In conclusion we think that whilst the elections are likely to pass without apparent incident, the nature of the coalition that emerges holds potential slow-burning implications for many asset classes.