The German elections could be a game changer. It is still too early to tell what impact they will have on future German and European policy, but the immediate reception they are receiving in Germany suggests it could yet prove profound.

Germany

But, first things first. After an unconvincing campaign, Merkel was re-elected Chancellor for a fourth time. As impressive as that is, and perhaps because it was so widely expected, the focus has been on the decline in support for her party, the rise of the right wing AfD who received one in eight votes (although only 3% among those over 70) and the inevitability of a protracted process for Chancellor Merkel to form a coalition.

Jamaica

Once the exit poll was released, the widespread expectation was for a "Jamaica coalition" (because of the colours of the parties of yellow, black and green) between Merkel's CDU (who won 200 of the 709 seats, a decline of 55 seats and their worst performance since 1949), its sister party the CSU (who have 46 seats but who saw a big drop in support), the pro-business FDP (a right-wing party who have 80 seats) and the Greens (67 seats).

Although this is seen as the most likely outcome, it may take some time to form a coalition. Some analysts predict another election. We do not agree, but such uncertainty could impact business confidence. It is not clear how this will impact policy towards the EU, as the Greens and FDP have differing views, particularly towards EU issues.

France

It is also unclear how Franco-German relations will develop. Shortly after his victory, French President Macron was described in the media as Germany’s “expensive friend” and his ideas for EU reform received a mixed reception in Germany. It remains to be seen whether hope of more co-ordination between the two most powerful countries in the euro area towards EU reform is now put on the back burner while Merkel focuses on domestic issues.

This wouldn’t sit well with Macron. His pro-European speech this week highlighting his ambitious, proposed reform agenda for the EU recognised the need for co-operation from his German counterparts for his vision to succeed. Judging from recent weeks, it also needs the French unions to buy into it too.

Key aspects of Macron’s speech highlighted his aspirations for:

• a bigger European budget to fund common investments and stabilize economic shock,
• an EU finance minister (but some of Merkel’s new coalition partners are wary of EU fiscal union),
• a multi-speed Europe, defined by levels of ambition (a sensible proposal in line with some serious thinking but at odds with Juncker’s recent vision),
• a common European intervention force, defence budget and doctrine for action (mirroring the “ever closer union” mentality),
• a common area for border management,
• reforming (again) the common agricultural policy,
• convergence of tax policies across the regions,
• an adjustable minimum wage, and
• reducing the European Commission to 15 members and a launch of a group for overhauling Europe.

Some key aspects of this are compatible with the previous German stance, but the impact of Sunday’s election result and the increased support for the AfD and the strong position of the FDP could threaten Merkel’s ability to co-operate. Indeed, other concerns, such as about migration, as well as the cost of bailouts associated with euro membership, could shape German politics for years to come.

UK

It remains to be seen what the impact is for the UK and the forthcoming Brexit negotiations. In particular, it will be interesting to see whether the German election outcome tilts things in favour of the business lobby. They have most to lose from no deal with the UK, a huge export market, and are known to want a deal. Indeed, business groups across France and Italy may likewise feel empowered, particularly in the light of the UK Prime Minister’s more conciliatory tone in her Florence speech and proposal for a two year transition deal.

Market Impact

This week European equity markets have remained unperturbed by the election results, although the euro has weakened slightly versus major currencies after a period of strength this year. Nevertheless, markets do not like uncertainty and will thus be watching closely to see how this might impact future policy. Also, we have an imminent unofficial referendum in Catalonia and it won’t be long until the Italian presidential election rolls into view. Recent developments are unlikely to alter ECB policy, which is accommodative and supportive of economic growth and financial assets. At Netwealth, we prefer European equities to US equities. We think the current economic outlook will continue to support European earnings growth, whilst on a relative basis, valuation and monetary policy also remain supportive. Naturally, we continue to monitor whether the recent political developments will change our allocation outlook.