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Research Note: Post-Election Outlook
Brian Dolan, Director of Research
German voters went to the polls on Sunday and fulfilled what many pre-election surveys suggested, namely that neither major coalition party would win enough votes to claim a majority in the Bundestag. The provisional results give the CDU/CSU a total of 225 seats in the lower house, the SPD 222 seats, the FDP 61, the Greens 51 and the Left Party won 54 seats. The election results will remain provisional until the Dresden district is able to cast its ballots on Oct. 2.
The election result crystallized the market's worst fears in terms of creating a political impasse ahead of very difficult reform policy decisions that are needed to pull Germany out of its worst economic slump in recent memory, and this has led to losses in German stocks, bonds and renewed weakness in the Euro currency. The focus now shifts to the major parties seeking to forge a coalition that is able to form a majority in parliament. The parties have 30 days to engage in coalition-building before the newly elected Bundestag must convene and elect a new Chancellor.
The leading scenario for a majority coalition to be formed centers on the opposition (CDU/CSU/FDP) luring the Green party to break from the SPD and join a center-right coalition government. The Greens are likely to seek significant concessions from the CDU if they are to abandon Chancellor Schroeder and their coalition partner, the SPD. This scenario would be the most favorable in terms of creating a positive market reaction (EUR higher, stocks higher) since the resultant coalition would be 80% aligned to a platform of economic reforms favored by businesses. This coalition will be the first option explored and could be settled relatively quickly, conceivably by the end of this week.
The other major scenario involves a 'grand coalition' in which the two largest parties would form a coalition government and rule together. The major stumbling block along this road initially focuses on who would be chancellor. Given the CDU/CSU's lead over the SPD, they would have the greater claim to name a chancellor, but Chancellor Schroeder of the SPD is showing extreme reluctance to step aside, having risen from the political ashes for a second time. If a grand coalition is to be formed, Schroeder will need to step aside, and he is likely to demand that CDU chancellor candidate Dr. Angela Merkel also step aside and the CDU name another as leader. The net result, however, would be a coalition government that is virtually evenly divided against itself and intransigent on reform philosophy. The market is likely to be more concerned by this outcome than any other.
There is also the possibility that negotiations will not yield a majority coalition, leading to a parliamentary process in which, after two votes fail to produce a majority for a chancellor, the president of the Republic could either name a chancellor or dissolve parliament and call for new elections. This would obviously follow protracted negotiations and leave the cloud of political uncertainty hanging over Germany for the maximum allowable time, which would in turn keep German markets and the Euro under pressure.
The final potential scenario, and a real dark horse were it not for Chancellor Schroeder's reinvigorated grasp on power, involves the SPD/Greens seeking the support of the Left Party, a new political group of disaffected SPD-members and former communists. Schroeder has sworn he would never consider forming an alliance with the Left Party, but that was before the election results made it necessary. In the sense that this scenario would result in an end to the political stalemate, it would be supportive of German markets in the short run. But the victory of the ruling coalition would disappoint markets that are looking for more aggressive economic and social reform initiatives over the long term.
Looking at the overall market reaction to the German election, the Euro predictably fell to major support levels at 1.2100-20, losing about 1 cent vs. Friday's close. I would suggest that other issues are likely to push the German political situation into the background, at least for the next several days. Tuesday's Fed rate decision will be pivotal in determining near term market direction for the US dollar and treasuries, while the course of Hurricane Rita, which threatens again to disrupt Gulf oil production and refining, remains the focus of panicked commodity markets.
The Euro is likely to remain under pressure while the German political drama unfolds. But there is little reason to expect a major collapse in the Euro due to political wrangling after an indeterminate election. The Germany economy has been flat-lining for several quarters now, and the Euro is still higher than it was two years ago. Moreover, the structural changes anticipated by either side are long-term fixes to entrenched systems that will take time to actually rejuvenate growth.
The downside for the Euro remains the path of least resistance, but traders need to focus on other more urgent issues (Fed, commodities, Rita) and keep the German political drama in perspective.
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