Angela Merkel remains, as expected, Germany’s Chancellor in the coming four years that are critical for the EU/euro, the Brexit process and geopolitical stability. The result means that Merkel must now govern the country from a weaker position and in a new political landscape as CDU/ CSU lost support and the number of parties in the Bundestag increased from 4 to 6. The election shows that Germany isn’t immune to anti-establishment forces: extremism and populism. Germany has a global top position in economic strength, which annoys other euro zone countries and the US. A somewhat more expansionary fiscal policy is in the pipeline but without excesses or surprises. It may take weeks, even months, before we know what a new coalition will look like but it seems like a first attempt will be for Merkel to discuss the issue with FDP and the Greens. For re-elected Merkel it is time to start writing the political will as EU/world leader.
1. Who is the winner and the loser?
Angela Merkel and CDU clearly lost support, but will get a new 4-year term. Merkel thus confirms her position as the obvious EU and world leader. The Parliament (Bundestag) also gets two additional parties that change the political landscape: anti-immigration Alternative für Deutschland (AfD) that enters parliament for the first time and liberal FDP that re-emerges in parliament after four years without representation. The biggest loser is SPD and its leader Martin Schulz, who initially got some support but failed against a strong Merkel despite the criticism of the Merkel’s handling of the refugee crisis in 2015.
2. What decided the outcome of the election?
Migration and security issues, and economic in-equality, were the key themes during election campaigns. However, despite the criticism of Merkel's refugee initiative in 2015, and with already twelve years in power, Merkel nevertheless was seen as guarantor of continuity, stability and economic strength. Questions about Europe's future, digitization and the economy got much less focus during the election debates.
3. What does the new government look like?
Negotiations will now begin and they are expected to be more complicated than after the 2013 election when a major coalition was, in principle, the only alternative. Today, two government solutions are possible: Most probable is a coalition between CDU/CSU and FDP. Given what the result so far indicates, also the Greens will have to be included to reach a parliamentary majority. The alternative is a continued CDU/CSU and SPD coalition. As SPD has indicated that it will go into opposition this scenario is probably only an emergency alternative if CDU/ CSU in the end is not able to cooperate with other parties. Irrespective of alternative, Merkel's coalition partner is expected to have a long list of demands for its support that will complicate the negotiations. Coalition partners are, for good reasons afraid of being “politically killed” by Merkel’s CDU ahead of next election in 2021 as it has happened before (for FDP in the 2013 election and SPD in 2017).
4. Who is the next German Minister of Finance?
Wolfgang Schäuble (CDU), with his credibility and long experience, is expected to continue for another four years. Schäuble, who is unpopular in some EU and euro zone countries, is needed as an important political counterweight to the new EU Finance Minister, who is expected to be appointed at the end of 2017 (and according to speculations may be a Frenchman). Schäuble is seen as an important guarantor for the euro's stability.
5. In which areas will economic policies change?
With Merkel as the Chancellor and Schäuble as the Minister of Finance, economic policy will be characterised by continuity with a strong business focus. However, due to changes of the political landscape, a more compromise-oriented and expansive fiscal policy is expected. The focus is on reduced income taxes and increased infrastructure investments and defense spending. German government finances can withstand a more expansionary policy, but faces an increasing risk of becoming overheated.
6. How is monetary policy (ECB) affected?
The possibility for the ECB to initiate a policy normalisation process increases for three reasons: 1. the political risk in the euro zone is further diminishing (although Italy's election in 2018 brings new challenges); 2. political steps towards increased euro area integration and fiscal coordination; 3. a somewhat more expansionary German fiscal policy. Our forecast is that the ECB later this year will decide to reduce its monthly bond purchases in 2018.
7. How has Brussels reacted on the result?
With German and French elections behind us, the future of the EU and the euro will get more attention. This is something France's President Macron is expected to say in a keynote speech about the EU/euro on September 26. But what the new Berlin government looks like is not yet known. There is a risk of a somewhat less EU friendly coalition if the FDP is included in the coalition than if SDP remains as the CDU’s partner. Germans are generally positive about the direction their country is taking but are dissatisfied with where the EU is heading. If Macron chooses to drive the process too hard towards EU federalism and multi-speed EU in the next few months, the resistance in Germany to integration is expected to increase.
8. What does the election imply for the EU/euro?
Since the next four years are expected to be Merkel’s last as Germany’s Chancellor, she can afford tougher policies both on domestic and global level. It is time for Merkel to prepare and write her political will. In light of this, it is positive for the euro/EU that Germany and France take clear leadership in coming years, but we should be prepared for a bumpy ride.
9. What is the impact on the euro and bond yields?
Currently the euro zone has economic tailwind. In addition, the ECB is expected to initiate a monetary policy normalisation process in the autumn. Overall, the euro and stock markets are supported by increasing optimism. The downside risks to the euro zone are primarily linked to political events; the deteriorating security policy situation globally, question about Russia’s and Turkey's political future, the instability in the Middle East and the near-term referendum in Catalonia (on October 1).
10. How will market react on the election result?
Although Germany is now facing a new political landscape, the election results were broadly in line with expectations and opinion polls. However, we currently do not know what the government will look like and we do not know the result of negotiations between parties that politically are not that close in all issues. Still, less uncertainty means support for the euro and rising stock market and bond yields.
11. What does the election means for US relations?
German-American relations are frosty and the personal chemistry does not seem to work between Chancellor Merkel and President Trump. The fact that Germany's economy is strong, and is running a very large current account surplus (see table on page 2), has put Germany on the US “watchlist” as a possible currency manipulator. This continues to influence German-American relations.
12. Will the Brexit process be affected?
Possibilities to make progress in EU-UK discussions should improve when Berlin can focus more on external issues such as the future of the EU/euro and economic and political relations with other countries. Merkel wants a constructive solution to Brexit, but the process is very complex and becomes even more complicated by British domestic policy issues and the risk of a new election.
13. Is the election result good or bad for Sweden?
Political stability in Europe and a strong German economy – Germany is Sweden's most important export market – is good for Sweden. Nevertheless, major question marks remain about Sweden’s future relationship with the euro zone and its position within the EU. Sweden will probably try to build stronger ties to Germany when (if) the UK leaves the EU.