The demise of the German government may benefit European markets

The collapse of Germany's government may offer a potential boost to the euro zone's struggling economy, with increased government spending likely to support the currency and stock markets, though the future remains uncertain.

Markets are already reacting to the possibility of higher government borrowing to stimulate economic growth, with a key bond market indicator of debt issuance reaching a record high.

One key issue behind the coalition's collapse was the disagreement over suspending Germany's debt brake, which restricts borrowing. Market reactions suggest that fresh elections in February could bring clarity to an economy that narrowly avoided a recession.

German stocks outperformed European counterparts after news of the government collapse last Wednesday, reflecting a more optimistic sentiment, especially just hours after Donald Trump's U.S. election victory, which raised concerns about potential tariffs impacting Europe's largest economy.

Zurich Insurance Group's Chief Markets Strategist Guy Miller noted that Germany's economic stagnation has largely been self-inflicted due to its adherence to the debt brake, despite the economy needing more support. He added that the collapse of the coalition could lead to more fiscal flexibility in the 2025 budget.

Debt Brake Dilemma

Economists have long criticized the debt brake, which was introduced in 2009, for restricting Germany's economic growth, with the country expected to shrink this year. ING's Carsten Brzeski estimates that a 1-2% increase in government spending over ten years could raise potential growth from the current 0.5% to at least 1%.

"Germany doesn't face a public finance crisis," Brzeski said, pointing out that with debt at only 63% of GDP, it has more fiscal leeway than countries like France and Italy. "If reforms can be paired with looser fiscal policies, they should be pursued," he added.

The International Monetary Fund has also suggested Germany consider easing its debt brake, and any signs of increased spending could bolster European shares. The pan-European STOXX 600 index is up 6% this year, significantly lagging behind the 26% gain of the U.S. S&P 500.

Barclays suggests that hopes for a pro-growth policy shift could trigger a revaluation of German equities, while Citi anticipates that tax cuts proposed by the opposition Christian Democrats, who lead in the polls, could support the stock market.

The euro, which dropped to a low of $1.06 on Tuesday, could also benefit from this shift in policy. Societe Generale's FX strategist Kit Juckes noted that Germany, now holding more foreign assets than Japan, has significant capital that could be invested in its economy. He believes such investments, particularly in German government bonds, could stimulate the economy and have a substantial impact on the euro if the government signals a policy change.

A shift in Germany’s stance could also pave the way for more joint European spending, especially as the European Union faces pressure to invest heavily in boosting its competitiveness. The election of Trump may accelerate this need for increased defense spending within the bloc.

"A change in leadership in Germany is crucial for advancing European integration," said Gilles Guibout, Head of European Equity Strategies at AXA Investment Managers. He welcomed the sacking of Finance Minister Christian Lindner, a fiscal conservative, but cautioned that whether this leads to meaningful change remains uncertain.

Hold On!

While political instability may lead to short-term challenges for the industry and dampen sentiment, the upcoming elections could provide further clarity.

The conservatives, expected to lead the next government, may limit the scale of any spending increase. Their leader, Friedrich Merz, is keen on preserving the debt brake, and he wants to see favorable conditions for investing in pro-growth programs, while also controlling welfare spending. Merz has opposed further common EU debt.

Economists are divided on whether the debt brake will be reformed or if Germany will pursue off-budget spending, which would require a large parliamentary majority.

Goldman Sachs predicts that the conservatives may support only modest amendments to the debt brake, with additional spending of around 0.5% of GDP, leaving fiscal policy as a drag on growth.

Macquarie strategist Thierry Wizman suggests betting against the euro, given the uncertainty surrounding government reform.

Others, however, believe change is inevitable. Davide Oneglia of consultancy TS Lombard expects snap elections to bring urgent discussions on Germany's economic model and EU security risks to the forefront. "The main risk is that they fail to embrace a necessary paradigm shift and revert to outdated economic strategies, which could lead to a harsher reckoning for both the German and EU economies," he said.

 

 

 

 

 

 

 

 

Paraphrasing text from "Reuters" all rights reserved by the original author.