PICTET WEALTH MANAGEMENT FLASH NOTE ASSET ALLOCATION & MACRO RESEARCH 06 August 2021 GERMANY: MACRO AND POLITICS WHAT COMES AFTER THE END OF THE MERKEL ERA? SUMMARY Author › German federal election on September 26 will be the major political event in the NADIA GHARBI, CFA euro area in H2 2021. [email protected] › The election will mark the end of Angela Merkel’s era in power (2005- 2021). What comes after is highly uncertain. › There is an increasing possibility that it will take tortuous coalition negotiations to form a government, which could be made up of three parties. This could hinder decision taking and ambitious initiatives. › Should the CDU/CSU together with the Greens lack the seats to form a majority, the FDP party could be invited to take part in a coalition government. A “traffic light” coalition (Greens-SPD-FDP) remains the most likely alternative to a CDU/CSU- dominated one. › The question is whether the election will mark a shift in German fiscal policy. Our view is that we will see fiscal policy become more expansionary, but to what extent depends on the kind of government coalition that prevails. › The emergence of a Black (CDU/CSU)-Green coalition would probably lead to a modestly looser fiscal stance, mostly in the form of increased public investment. › While growth will be an important topic, inflation is likely to catch most attention in Germany. Yet while headline inflation could exceed 4% by the end of the year, we see this as a temporary spike. A three-party coalition increasingly likely With less than two months to go before the German federal election on September 26, polls are pointing to an uncertain outcome. In recent weeks, the election campaign has been overshadowed by serious flooding in parts of the country and a fourth wave of the coronavirus. But it seems that no single party has been able to turn these events to its advantage at this stage while controversies have swept over two of the main candidates for the chancellorship, Annalena Baerbock (co-leader of the Green party) and Armin Laschet (leader of the CDU). The centre-right CDU/CSU alliance remains ahead in opinion polls, but momentum has been slipping since March, and it now has less than 30% of voting intentions. After a slide, the Greens seem to have stabilised at just below 20% of voting intentions (see chart 1). Based on such polling, a CDU/CSU-Green (Black-Green) coalition, our original base case, is no longer assured of achieving an absolute majority in the Bundestag (see chart 2). Should this turn out to be the case, the FDP could be sounded out to join a Black-Green coalition. Negotiations to form a ‘Jamaica’ coalition (Black- Green-Yellow (for the FDP)) coalition failed in 2017 but the prospects seem better this year. A ’traffic light’ coalition (Green-SPD-FDP) remains the most likely alternative to a CDU/CSU-dominated one. A grand coalition between the CDU/CSU and SPD has been ruled out by the latter, but it could change its mind. 1 OF 8 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 06 August 2021 GERMANY: MACRO AND POLITICS WHAT COMES AFTER THE END OF THE MERKEL ERA? CHART 1: GERMANY – NEXT FEDERAL ELECTION, AVERAGE VOTING INTENTIONS (UP TO AUGUST 4, 2021) 45 Union (CDU/CSU alliance) SPD FDP AfD Die Linke Grüne monthly average voting intentions, % 40 35 30 25 20 15 10 5 09.17 12.17 03.18 06.18 09.18 12.18 03.19 06.19 09.19 12.19 03.20 06.20 09.20 12.20 03.21 06.21 09.21 Source: PWM - AA&MR, Various polls, 4 August 2021 All in all, based on current opinion polls, the risk that the next government will have to rely on a three-party coalition has increased. This could mean protracted coalition talks and a less ambitious government agenda. For the record, it took almost six months for a CDU/CSU-SPD government to be formed after the last elections in September 2017. CHART 2: OUR ASSESSMENT OF COALITION OPTIONS BASED ON LATEST POLLING (AVERAGE) 70 % Seats "Bahamas" "Germany" "Black/Green" "Jamaica" "Grand" "Traffic light" coalition coalition coalition coalition coalition coalition 60 50 40 30 20 10 0 Union/FDP/AfD Union/FDP Union/SPD/FDP Union/Grüne Union/Grüne/FDP Union/SPD SPD/Grüne/FDP SPD/Grüne SPD/Grüne/Linke Source: PWM - AA&MR, Various polls, our calculations, 4 August 2021 More (and greener) spending German and, to some extent, European economic policies in the coming years will depend a lot on the composition of the future government in Berlin. All of the major parties’ manifestos share ambitious climate goals—but with differences in the way each of them proposes to achieve these goals. Views are also wide apart when it comes to domestic and EU fiscal policy. 2 OF 8 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 06 August 2021 GERMANY: MACRO AND POLITICS WHAT COMES AFTER THE END OF THE MERKEL ERA? Having lagged since the global financial crisis, public investment in Germany has only caught up with levels in other large EU countries in 2020 (see chart 3). Before the pandemic, Germany had been reluctant to spend more, but many expect that it will want to exploit current low interest rates—even though strong support for fiscal discipline among voters has encouraged governments in Germany to stick scrupulously to constitutional rules designed to avoid deficits and reduce debt. Self-imposed austerity reflects a concern about long-term debt sustainability as an ageing population places an increasing burden on the social-security system and heightens the importance of keeping the debt-to-GDP ratio under control. CHART 3: EURO AREA PUBLIC INVESTMENT IN % OF GDP 7.0 % of GDP Germany France Italy Spain 6.0 5.0 4.0 3.0 2.0 1.0 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21 Source: PWM - AA&MR, AMECO, 4 August 2021 The question is whether the September election will mark a more lasting shift in attitude regarding fiscal policy. Our view is that while we may see an expansionary tilt to fiscal policy, how far depends on the composition of the next government. We have tried to summarise parties’ different views on fiscal policy in Table 1. The centre-right parties (CDU/CSU and FDP) aim to restore the constitutionally binding debt brake1 and 60% debt-to-GDP ratio that prevailed before the pandemic as soon as it makes sense to do so. In contrast, the Greens want to reform the debt brake to facilitate investment spending, proposing a EUR50 bn per year of public investment top-up over 10 years. It should be noted that a two-thirds majority in parliament will be required to change the constitutional debt brake. Such a majority is unlikely to emerge after the elections. But an alternative way to increase public spending would be to create off-balance sheet vehicles. This would probably be the path of least resistance for conservative parties. The CDU/CSU and FDP advocate no tax increases to pay for investment, with the latter proposing different forms of tax relief instead. By contrast, the Greens and SPD have 1 Note: German debt brake was introduced in 2009. It caps the federal government’s budget deficits at 0.35% of GDP and forces regional and local governments to run balanced budgets. 3 OF 8 FLASH NOTE PICTET WEALTH MANAGEMENT ASSET ALLOCATION & MACRO RESEARCH 06 August 2021 GERMANY: MACRO AND POLITICS WHAT COMES AFTER THE END OF THE MERKEL ERA? proposed tax increases for the highest income bracket as well as the introduction of a wealth tax. The German parties’ views on domestic fiscal policy are mirrored in their attitude towards EU fiscal policy. All parties agree on the need to reform the Stability and Growth Pact (SPG)2 rules, but not all want to loosen them. While EU fiscal rules remain suspended until 2023 because of the pandemic, the European Commission is due to deliver a report on their reform by the end of this year. While it is hard to predict what the Commission will recommend, the German centre-right parties (CDU/CSU and FDP) have made clear that they do not want fiscal rules to be loosened. However, a return to existing EU fiscal rules would mean countries on the EU periphery having to significantly consolidate their public finances, which could undermine the path to recovery. Conservative parties have also ruled out transforming the EU recovery package, Next Generation EU (NGEU), into a permanent fiscal tool. All in all, where there are important divergences between the German political parties on fiscal policy, we see room for compromise. There seems to be a broad consensus on the need for more public investment. The emergence of a Black (CDU/CSU)-Green coalition would probably lead to a modestly looser fiscal stance, mostly in the form of increased public investment TABLE 1: GERMAN PARTIES’ FISCAL STANCE FDP Union (CDU/CSU) SPD Linke Grüne With reform (allow for Reintroduction of debt brake (limits Yes but exploit fiscal Yes Yes - public investment with structural deficits to 0.35%) room more liberally a specific limit) Return to 60% debt-to-GDP ratio Yes Yes - - - Reliance on off-balance-sheet Domestic vehicles to increase public - (Yes) - - Yes investment Yes, for higher Yes, for higher Yes, for higher Higher taxation No No incomes incomes incomes Yes, to increase Fiscal rules (SPG) reform penalties for Yes, but no softening Yes Yes Yes infrigement EU NGEU building into a central fiscal (Yes) NGEU to be a No, NGEU a one off No, NGEU a one off Yes Yes capacity "durable step forward" Source: PWM - AA&MR, parties’ manifestos, 4 August 2021 A rapid glance at the German economy The German economy has been gradually recovering from the output drop it suffered in 2020.