Here we update our earlier views on the German elections scheduled for September 26, and the potential market implications. Since our introductory blog post, polls have shown marked swings and the race is currently wide open but a governing coalition is now likely to require three parties.
Political Themes and Priorities Revisited
As expected, the pandemic is likely to play only a minor role in the election given the advanced stage of European inoculation drives and the limited impact of the Covid delta variant on the economy. On the other hand, the importance of climate change as a key topic has been highlighted by the devastating floods in Western Germany earlier this summer. Consequently, several center-right politicians have argued for greater flexibility with respect to the constitutional debt brake. It is also possible that an emerging refugee crisis related to Afghanistan will dominate the air waves around election time, echoing the German experience with the flow of Syrian refugees in 2015. While this topic is likely to again favor parties on the (far) right of the political spectrum, it has not yet filtered into the polls.
Developments in Polls
Polling dynamics have changed dramatically since our initial blog in June. Compared to the voting intentions when the lead candidates were initially announced a few months ago (“Peak Green” euphoria), the economic reopening has boosted support for the main government party, the center-right CDU/CSU. However, since the floods in Germany in mid-July, sentiment has turned against the CDU after a couple of costly PR mistakes. Somewhat surprisingly given the perceived link between the natural catastrophe and climate change, the beneficiary has been the SPD (the current junior coalition partner on the center left), lifting them into second place ahead of the Greens for the first time since late 2018, according to a poll of polls. SPD politics are perceived as unexciting but solid with few mistakes, and Olaf Scholz, the party’s lead candidate and current Minister of Finance, tops popularity rankings. That said, all three main parties—CDU/CSU, SPD, and Greens—now poll in a close range around 19%-23%, with the CDU currently slightly ahead on average.
Coalition Mechanics Revisited
Critically, current polling suggests that no two parties are likely to gain enough seats to form a ruling coalition, in contrast to the situation a couple of months ago when conservatives and Greens had a majority. Coalition governments are the rule rather than the exception in Germany, but the potential need for a third party in the mix at the federal level is new—three-party coalition governments have only been constructed at the regional level.
At the current juncture, the Liberals (FDP) are a possible third component in a coalition, but just what coalition that might be is currently unclear. The remaining two parties likely to make it into the Bundestag—Linke on the (far) left and AfD on the (far) right—are either polling too low or are not politically palatable for coalition formation with the larger parties, or both.
Whether the FDP (party color: yellow) would be able to join a so-called “Jamaica coalition” with the CDU (black) and the Greens is unclear, as they abruptly pulled out of a similar negotiation after the 2017 elections, leaving the country in limbo and damaging the party’s credibility. Moreover, the FDP has committed to maintaining the debt brake in its current form—a potential stumbling block when negotiating with the CDU/CSU and especially the Greens who are intent on accelerating spending on climate-related issues as well as revising the tax code in ways that will be hard for the FDP to swallow.
Alternatively, the FDP could also form part of a “traffic light coalition” with the Greens and the SPD (red) if the ascent of the latter continues and Olaf Scholz becomes Chancellor, relegating Merkel’s party to the opposition after 16 years in power. However, it will be even more difficult to bridge diverging views in this constellation, and the shifts required—including on fiscal rules—might not be palatable with the FDP’s voter base.
Finally, another possible constellation is a continuation of the current grand coalition between CDU/CSU and SPD, and adding either the FDP or, more likely, the Greens (“Kenya coalition”). We believe these constellations are possible but only as back-up solutions as the SPD and CDU will not jump at another four years as coalition partners. That said, there is probably more programmatic overlap between the current coalition and the Greens than with the FDP, especially when it comes to the topics of climate change and fiscal rules. Finally, the SPD could appeal to the CDU to return the favor from four years ago and support a center-left coalition to avoid new elections.
Where Does This Leave Us?
Currently, the race is wide open and many more constellations are possible than was the case just a few months ago. That said, we think it is still highly likely that the Greens will be part of any coalition, but the need to bring a third party into the mix leads to more complex negotiations and compromises. It also likely makes any government coalition less stable.
Market Implications
In many aspects, a three-party coalition at the federal level in Germany is an experiment and there are higher risks to political stability, which is a new experience for post-war Germany. If the FDP is part of the governing coalition, the debt brake has more chances to survive per se, containing spending pressures. That said, more (diverging) policy priorities also promote more diversified spending, and we believe that ultimately a reframing of the domestic fiscal rule is the path of least resistance and has become more likely in our assessment. Moreover, there are possible spillover effects into the review of fiscal rules at the European level, likely to be concluded after the French elections in 2022. In terms of markets, we believe that yields on German government bonds are likely to rise under almost any scenario. Our conviction would rise further if the FDP were not to form part of the coalition.