LONDON, Feb 18 (Reuters) - The German election on Sunday may lead to a conservative-led coalition government under pressure for necessary reforms to boost the economy, while also facing opposition from populist parties.
Europe's largest economy could experience prolonged uncertainty as polls suggest the conservative CDU/CSU bloc, led by Friedrich Merz, may need one or possibly two partners to govern effectively.
A key focus will be on whether the government can amend self-imposed restrictions to allow increased spending to stimulate economic growth.
Here are five important questions for financial markets:
1/ What will investors be watching closely?
Investors will monitor how quickly a new government can be formed and whether there is sufficient support for fiscal reform among parties entering parliament.
Simon Keller, an equity research analyst at Hauck Aufhäuser Investment Banking (HAIB), stated, "It would be easiest if both the CDU/CSU and (centre-left Social Democrats) SPD have enough votes to form a coalition."
The presence of populist parties such as the right-wing AfD and left-wing BSW in parliament could disrupt hopes for significant fiscal reform, unsettling markets.
2/ Will the election lead to debt brake reform?
Market analysts doubt a drastic overhaul of the "debt brake" – a limit on spending – will occur, but anticipate a modest relaxation of fiscal policy.
Katharine Neiss, chief European economist at PGIM Fixed Income, indicated a small adjustment allowing more spending discretion could be likely, potentially benefiting the economy.
3/ How will the euro and bonds be affected?
An increase in government spending is likely to strengthen the euro and bolster the economic outlook. Morgan Stanley suggested a grand coalition (CDU/CSU and SPD) along with debt-brake reforms could be positive for the euro.
Higher fiscal spending might raise the supply of German bonds, impacting bond yields across Europe. Peripheral markets like Italy could also benefit from a potential CDU-led mainstream coalition focusing on German economic improvements.
4/ What implications does this have for equities?
German stocks linked to the economy could see a boost from corporate tax cuts and improved growth following the election. Barclays' head of European equity strategy Emmanuel Cau noted that the election could offer positive outcomes.
Investors seem to be anticipating the election results, with strong inflows into European equities excluding the UK. The DAX index is near record highs, while smaller companies have not performed as well due to weaker domestic growth.
5/ Will defense spending increase?
Rising defense spending appears likely as discussions regarding a possible Ukraine peace deal between the U.S. and Russia progress.
Expectations are that the debt brake will be revised to allow for higher defense spending, with long-term targets in line with NATO standards. Defense stocks such as RENK Group and Hensoldt have benefited from signals that increasing defense budgets might be easier under adjusted fiscal limits set by Brussels.
(This story has been corrected to reflect the dateline on Feb 18, not Feb 19)