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September 2017

German election: In Merkel we trust

German Chancellor Angela Merkel has won a fourth term but now faces tricky coalition talks after mainstream parties posted their worst results since the 1940s.

  • We see the outcome slowing momentum behind a Franco-German drive to promote deeper eurozone integration.
  • The powerful position of German finance minister could be key in coalition talks and the future of the eurozone.

Overview

We believe the outcome of the German election will have limited impact on financial markets but see it slowing momentum behind efforts to strengthen the eurozone. The election result also showed euroskeptic sentiments still run high in the bloc, as evidenced by the larger-than-expected 13% share for the right-wing Alternative for Germany party.

We prefer European equities over eurozone government bonds and credit amid a sustained, above-trend economic expansion and a steady earnings outlook. Companies with much of their cost base overseas should have some cover against a strong euro in the short term, we believe.

We see some scope for the U.S. dollar to regain some lost ground against the euro as the Federal Reserve presses ahead of policy normalization and inflation looks ripe for a potential rebound. We believe core inflation in the eurozone is likely to stay muted, keeping the European Central Bank accommodative.

Market update

Investors have not been pricing in a major risk event around the German election. Comparing the curve of the VSTOXX® index – the European equivalent of the VIX index, a common measure of equity volatility in the U.S. – ahead of the French and German elections this year shows investors anticipating volatility around the former, but a ‘normal’ curve with no equivalent price spike around the time of the latter.

Coup concerns versus putsch placidity

VSTOXX® term structure ahead of French and German elections

German Election

Source: Bloomberg as of September 14, 2017.

Investor positioning

As of September 21, $36 billion has flowed into European equity exchange traded products globally year-to-date, according to Markit and BlackRock. This represents about the same amount that flowed out of these exposures in 2016. A steadier political backdrop in Europe should support sustained, above-trend economic growth and some reform – and bolsters the case for considering the region’s equities, in our view.

Eurozone equities have performed well this year, although the gains have slowed somewhat.1 The MSCI EMU Index is up 12% in U.S. dollar terms, as of September 21st, but has gained 1.42% since August 1st. The MSCI Germany Index is up 9.03% this year, but is up 2.32% since August 1st. Interestingly, the recent outperformance has occurred despite recent euro strength, yet roughly 47% of sales revenues of the members of the MSCI Germany Index are generated outside Europe, whereas the Euro Stoxx Index, for example, sees around 30% of sales revenues generated outside Europe, as of 9/21/17.