German Coalition: 'Jamaica' Fails to Materialize – Markets Stay Calm
After the breakdown of coalition talks, we favor French equities over their German counterparts. Italian bonds could be vulnerable to higher political risks.
Political life has become significantly more complex in Germany. Investors' central scenario, an Angela Merkel-led 'Jamaica' coalition with the Christian Democratic Union/Christian Social Union (CDU/CSU), the Free Democratic Party (FDP), and the Green party, failed to materialize. This was unexpected, but the market response has been very muted so far despite the initial weakness in the EUR and equities. The longer-term impact can be significant, but with so many variables in the equation (leadership, coalition members, government size, ministerial assignments etc.), it may be too early to take a call. Immediate positive tail risks have diminished particularly for Eurozone reform. The German economy will rely on its very robust current pace of growth and the existing grand coalition government to see it through these extended negotiations, but the negative tail risk of another election and an even more fragmented electorate cannot be ignored. Against this backdrop, we emphasize that we recently turned more neutral on German equities versus their French counterparts and are less constructive on Italian sovereign bonds relative to their periphery peers.
After the Breakdown of Coalition Talks, Only Three Scenarios Remain
With chances of forming a four-party coalition now having ended, there remain three major routes German parties could take in the weeks ahead:
- Minority government: The current Chancellor Angela Merkel's CDU (and her Bavarian counterpart CSU) could attempt to form a government with either the Green party or the FDP. Both options would be short of a majority in parliament (Bundestag) by either 29 (with the FDP) or 42 seats (with the Greens). At the moment, this solution seems rather unlikely as it would not deliver a stable government and would very likely result in early/new elections.
- Grand coalition: CDU/CSU could once again try to form a government with the Social Democratic Party (SPD), though the SPD is still ruling out that option. It appears very likely that it will stick to this position despite pressure to form such a coalition probably increasing significantly in the coming days.
- New elections: The constitutional hurdles for new elections are relatively high (see Infobox). In addition, the latest polls, conducted before the coalition talks broke down, were relatively close to the September election outcome. As such, the hesitation to hold new elections is understandably high. From the current perspective, however, it still seems to be the most likely route forward. Pressure to form a government will even be higher after another round of elections. And even if the outcome would closely resemble the September election results, both the SPD and also the other parties involved in the recent coalition talks might be more inclined to form a government.
Economic Backdrop Very Strong
Despite the political impasse of recent months, the German economy continued to grow at a very robust 0.8% QoQ in Q3 2017, according to the latest flash estimate. The manufacturing Purchasing Managers' Index (PMI) remained at a 6.5 year high in October, suggesting that the strong growth momentum also carried into Q4. The solid growth environment is also reflected in the labor market, where the unemployment rate fell 0.4 percentage points in 2017 alone and is currently at 5.6%, the lowest value recorded since the reunification of Germany. In Western Germany, for which a longer time series is available, the unemployment rate of 5.2% is the lowest since 1981. We expect the breakdown of coalition talks and the prospect of new elections will do little damage to the current robust growth environment. It is unlikely to have a more meaningful impact on business and consumer confidence. In addition, fiscal policy should at the margin be somewhat tighter under a caretaker or minority government, as parliamentary approval for a more fiscal largesse may be difficult to achieve. However, a longer period of political uncertainty or a weak government without majority in parliament will likely take its toll as necessary reforms and political decisions will be delayed with further European integration ranking high on the agenda.
German Equities Have Less Scope to Outperform Compared with French Ones
At our last Investment Committee meeting and prior to the recent market declines, we became less constructive on German equities after having held a positive view through the autumn. The tailwinds from weakness in the EUR, a recovery in the auto sector, supportive news on economic growth from China, and upwardly trending domestic data had played out in favor of German equities. We believed investors would be well served by realizing gains from the strong performance observed in the third quarter (please see the "European Strategy – November 2017" presentation). Whilst per se the breakdown in coalition talks has little immediate read-through for large cap publicly quoted German firms, it may nevertheless weigh more on sentiment toward the country given that absolute valuations are high, dividend yields are low, and the earlier relative valuation discount has disappeared. It had been thought that a pro-European, pro-business stance of a new coalition combined with a modestly looser fiscal policy would be incrementally supportive for German equities, but that outcome now looks further away. We believe that positive economic and earnings momentum in France can create room for its outperformance versus its EMU peers. Now it appears that it has more immediate political momentum underpinned by a reform agenda, which seeks to address domestic structural issues even in the absence of any progress at the European level.
Italian Bonds may Underperform as Political Risk Rises
A very strong rally post the last European Central Bank (ECB) meeting, which saw government bonds from the periphery perform strongly, led us to take a negative view on Italian government bonds relative to their peers in the periphery and versus German Bunds. After the weekend, our conviction on this view has grown. As coalition negotiations progress, it is likely that the focus of German political discussions will turn more inward to the detriment of agreeing broader reforms that could be pursued at the EU level. We believe this could weigh on risk appetite in periphery countries, particularly Italy, given the general elections due early next year and in light of the recent adverse developments in the domestic banking sector. Sovereign bond spreads discount a benign political scenario and perhaps do not appropriately reward investors for greater political volatility ahead.
Corporate Credit Remains Well Supported by ECB Purchases
A positive economic cycle and improving operating fundamentals continue to speak in favor of corporate bonds despite the events in the weekend. Absolute valuations are not attractive, but the support of the ECB provides a floor to bond valuations. As a result, we interpret the news as adding to our conviction that it is potentially preferable to be invested in high-quality, investment-grade bonds rather than in low-quality, long-dated, high-yield issues. Investors seeking to enhance portfolio yield may prefer to take shorter dated exposure in lower quality names or to move higher in the capital structure (e.g. loans). Conversely, they may selectively wish to consider junior bonds of high-quality issuers.