How will the German general election impact the market? UBS provides a "predicted scenario".

As the German general election approaches, UBS has conducted an analysis of its impact. The parliamentary elections in Germany will take place on February 23, 2025. UBS expects that fiscal stimulus will provide some cyclical boost, but the bank believes that Germany's moderate growth potential is unlikely to significantly improve. For the German stock market, attention needs to be paid to potential corporate tax cuts, with a focus on the impact of these measures on the automotive, capital goods, defense, real estate, and utility sectors. Current Polling Results Currently, opinion polls indicate a change in the situation of the ruling coalition in Germany. The latest opinion polls and UBS evidence lab political probability monitoring show that the center-right parties Christian Democratic Union (CDU)/Christian Social Union (CSU) are in first place. However, to secure a majority, they would need to find a coalition partner for a new government (potentially the center-left Social Democratic Party (SPD) or the Green Party), but this would require compromises, making radical reforms less likely. Based on past experiences in coalition negotiations, the new German government may come into power as early as the end of April. Current polling shows that the center-right CDU/CSU led by Merz is ahead (32%), followed by the far-right Alternative for Germany (AfD) (19%), SPD (16%), the Green Party (13%), and the far-left SED alliance (5%). The Free Democrats currently have a support rate of 4%, indicating that they may not cross the 5% threshold and may not enter the next federal parliament. According to the current polls, the probability of CDU/CSU winning the most seats is 94%, followed by AfD (15%) and SPD (9%). When explaining the current trends, it is worth noting that in 2021, opinion polls underwent significant shifts in the two months before the elections: in July 2021, SPD trailed behind CDU/CSU by a margin similar to today (15% and 30% respectively); on election day, SPD surpassed CDU/CSU with a support rate of 25% compared to CDU/CSU's 22%. Based on current polling results (taking into account the 5% threshold rule for counting majorities), there are various coalition options. Two-party alliances include CDU/CSU-SPD alliance (the so-called "grand coalition") or CDU/CSU and Green Party alliance ("black-green alliance"). However, a key uncertainty is whether some parties (such as the Left Party or Free Democrats) can weaken the federal parliament by gaining three direct seats with a national vote share below 5%. The fewer parties represented in parliament, the lower the threshold for the coalition government to secure a majority. Although the current results seem relatively clear, UBS highlights that opinion polls may still change in the final weeks before the elections (as they did in 2021). The focus is on whether CDU/CSU, SPD, and the Green Party can secure a two-thirds majority in parliament, which is necessary to ease the debt brake. At the current stage, opinion polls show that CDU/CSU, SPD, and the Green Party can control 72% of the seats in parliament, so the far-right AfD and the far-left SED alliance would be unable to stop such a change. Policy Demands of Various Parties There are common themes in the manifestos of the various parties in Germany. Suggestions include: (1) tax cuts for families; (2) lower corporate taxes or investment subsidies; (3) lower energy charges; (4) increased defense spending; (5) reduction of bureaucracy. However, there are significant differences in labor market and pension policies. From a macro perspective, changes in fiscal policy are the most closely watched. The SPD calls for a "moderate reform" of the debt brake rule, which limits government borrowing to 0.35% of domestic product, to increase defense investment. The CDU/CSU hints at a moderate reform of the debt brake but pledges to maintain the policy in their election manifesto. The Green Party also calls for a reform of the debt brake to increase public expenditure. In contrast, the Free Democrats and AfD are committed to preserving the debt brake policy. Despite the different recommendations in fiscal policy, UBS anticipates that if a two-thirds majority can be achieved after the elections for necessary constitutional reforms, the debt brake will be relaxed. This may lead to some limited fiscal stimulus in 2026 (with UBS estimating a deficit of 0.7% of GDP). Macroeconomic Impact: Three Scenarios UBS predicts three potential scenarios: (1) the status quo/deadlock scenario (UBS predicts a 25% likelihood), where no agreement is reached on fiscal stimulus and substantial policy changes, leading to weaker growth prospects than forecasted. (2) The moderate cyclical boost scenario (UBS predicts a 60% likelihood - the base scenario), where reforms to the debt brake, increased defense public spending, and moderate additional support for families and businesses are implemented. By 2026, economic growth would rise to a potential level of 0.8%, but structural obstacles would still exist. (3) The economic growth stimulus scenario (UBS predicts a 15% likelihood), which accompanies significant increase in fiscal expenditure to raise Germany's medium-term growth rate, and a structural reform agenda. Foreign Exchange Impact In terms of foreign exchange, UBS strategists believe that the ongoing impact would mainly be negative for the euro in the deadlock scenario (1) and positive in the growth stimulus scenario (3), with limited impact in the base scenario (2) of a moderate fiscal stimulus. UBS economists forecast that by 2026, with the relaxation of the debt brake, fiscal deficit as a share of GDP would be 0.7%, the base scenario which has a 60% likelihood, would have a moderate positive impact on Germany's growth prospects. This would help support Eurozone rates under market pressures. Besides direct growth support, any indication that the German political system can overcome rigidity and take a more market-friendly stance would be favorable for investor sentiment. However, UBS states that if other factors discussed above (such as US risks) dominate, whether there is enough meaningful rebound for the euro in 2025 is doubtful, unless these issues have already led to a very broad sell-off of the euro, resulting in a reflexive rebound.In the future, the euro could rebound to 1.1 against the US dollar. However, if a stalemate situation (1) occurs when the euro is under pressure due to risks such as US tariffs or political turmoil in France, the risk of high volatility and selling pressure on the euro will increase accordingly. The market will become more comfortable with the idea that the euro against the US dollar will remain below parity for a longer period of time.The last possible outcome is that the stalemate result is not related to the current situation, but more due to the unexpected strong performance of the AfD BSW. Such a result is not only making German economic observers panic, but also causing anxiety for those concerned about the long-term stability of the Eurozone's political and financial institutions. This result, combined with the realization of US tariff risks, could push the Euro closer to levels above 0.9500 against the US Dollar, with the last test of this level being in September 2022. Interest rate impact In terms of interest rate strategy, the election results are seen as good news for the safe-haven status of German government bonds. Concerns about Germany's competitiveness have been a key focus for global investors, so UBS believes that the German elections and their impact on promoting growth through fiscal stimulus policies will be positive for the safe-haven status of German government bonds. Weak performance of German government bonds (especially compared to peripheral countries in the Eurozone and swap bonds) is one of the reasons for the weak economic outlook in Germany. In a mild cyclical boost scenario (2) or growth stimulus scenario (3), demand should remain strong. In these cases, additional fiscal support may enhance business confidence and have a positive impact on growth. UBS believes that despite the uncertainty surrounding the upcoming elections, the current levels provide an opportunity to go long on German government bonds. UBS's target for the 10-year German government bond yield at the end of 2025 is 1.90%, currently at 2.58%, nearly 40 basis points higher than the same period last year, approaching the peak levels of 2024. After four rate cuts by the European Central Bank last year, the 10-year German government bond yield fell, hitting a bottom near the 2% level in November, but recent re-pricing of US policy rate expectations and an increase in Eurozone bond supply expectations for the first quarter pushed the 10-year German government bond yield back to levels seen at the beginning of last year. Furthermore, UBS expects the European Central Bank to cut policy rates four more times this year. US imposition of import tariffs on EU exports poses downside risks to Eurozone economic growth, which may lead the final rates of the European Central Bank to be lower than UBS's current forecast of 2%. UBS does believe that due to rising spending expectations, the risk to Germany's supply prospects in 2025 is tilted to the upside. As discussed in this article, potential debt brake reforms may create space for deficits of around 0.7% of GDP by 2026. This would mean Germany would issue an additional 30 billion euros in bonds, provided fiscal space is fully utilized, with any additional spending being financed through bond issuance. However, this scenario may occur in 2026 rather than in 2025. Germany's total bond issuance this year is expected to reach 267 billion euros, a decrease of nearly 9 billion euros from 2024, providing a buffer for potential fiscal spending for the year. Stock market impact For European stock market strategies, the potential for corporate tax cuts is seen as the most important impact. A 5% reduction in tax rates would increase German corporate profits by 7%. It is believed that the potential impact of limited fiscal stimulus measures on German companies can be negligible, let alone on broader European stock markets. However, the additional spending of 30 billion euros could have some impact on certain companies (such as defense and the broader capital goods sector). At the industry level, UBS's team focuses on the favorable aspects of the automotive, capital goods, defense, real estate, and utilities sectors. The German elections may have a significant impact on the German and wider European stock markets. The most important policy shift proposed would be the reduction of corporate tax rates. The current rate is 30%, the highest in the world, and the policy change could bring about permanent changes. A permanent reduction of 5% in the corporate tax rate would increase German after-tax profits by about 7% (based on an estimated pre-tax profit rate of 10%). Given the low proportion of profits generated in Germany, the impact on non-German companies would be relatively small. While investors are excited about the potential for German fiscal expansion, UBS believes this will not be a significant driver of the stock market in the coming year. Firstly, the major parties "willing" to talk about lifting the debt brake, but their policies still support retaining it. Secondly, changing debt brake rules requires a two-thirds majority in parliament to amend the constitution. Finally, UBS believes that the potential or anticipated scale of deficit expansion is around 0.7% of Germany's GDP, which would only raise Germany's GDP by 0.3%. Nevertheless, considering Germany's investment needs, an additional expenditure of 30 billion euros per year by the German government will play a role in certain areas, including parts of the defense and broader capital goods industries. UBS believes that for the German or European stock markets, this is more of a driving factor for specific stocks rather than a game-changer. UBS supports the broader view that, with policy support, defense and capital goods are growth areas in Europe. When considering opportunities in Germany, UBS points out that it is important to remember that the DAX index is made up of highly globalized companies led by SAP, Siemens, and Allianz. Calculated by cap-weighted measures, about half of German companies' revenues come from across Europe. Even in the MDAX (mid-cap) index, German companies have a highly international exposure. From a macro perspective, what is more important for the German stock market is overall European growth and sales to China. For many German companies, these areas remain challenging, especially for some automotive, chemical, and machinery companies.