Germany stocks outperform despite political uncertainty

In the last few months German equities have been one of the best performing markets, outpacing the UK and US even though for much of this period Germany has not had a functioning government.

The German federal elections in mid-February provided a moderately positive outcome for markets, with the Christian Democrats (CDU/CSU) securing the largest vote share and Friedrich Merz set to be the next chancellor. Outgoing chancellor Olaf Scholz’s Social Democratic party (SPD) suffered sizable losses but still came third and are expected to form a two-party government with the CDU/CSU, albeit with a slim parliamentary majority.

Merz has said he’ll move quickly to form the new government, but it may face limited room for manoeuvre due to the strong showing from the far-right Alternative for Germany (AFD), which doubled its vote share, and gains for the left-wing Die Linke.

Germany’s financial position has been at the heart of these elections, as the eurozone’s largest economy has struggled in recent years. German GDP contracted 0.2% last year following a 0.3% decline in 2023, registering back-to-back
negative readings for one of the country’s most protracted periods of economic stagnation in decades. In the last five years, Germany has lagged behind its peers, posting negative real growth (nominal growth – inflation).

External factors such as the Covid-19 pandemic and the Russian invasion of Ukraine have weighed on economic activity, but the relatively poor economic performance has led to German politicians looking inward. Deindustrialisation has become a central topic of discussion as Germany’s traditionally strong position in manufacturing has been eroded away. Germany’s reliance on cheap Russian energy was laid bare after the invasion of Ukraine and price pressures rose rapidly, causing the European Central Bank to raise key interest rates, further slowing an already stuttering economy.

Fiscal stimulus has been seen as one way out of the current malaise, but this has been restricted due to the so-called debt brake — a mechanism enshrined in the constitution after the 2008 financial crisis which limits German government borrowing to 0.35% of GDP. Outgoing chancellor Olaf Scholz dismissed finance minister Christian Lindner in early November, seemingly due to Lindner’s reluctance to release the debt brake restriction. This led to the collapse of the government and federal elections.

The performance of German stocks in recent months shows that political uncertainty is not necessarily a negative for investment performance. It depends on what the uncertainty may bring. While the incoming coalition is an unknown entity to some extent, it is still seen as likely being less disruptive than a coalition involving the far-left or far-right parties. The sequence of events that brought down the last government also suggesting the incoming government may well be more open to fiscal stimulus, which after years of sluggish economic growth could provide a much-needed kick start to the EU’s largest economy.

This also shows the potential importance of relative valuations and sentiment. Following Donald Trump’s election victory, a large swathe of money managers saw the US extending its run of outperformance and European stocks continuing to lag. With sentiment on Europe downbeat, it does not necessarily require an abundance of positive news to turn the tide.

It is still early days, but recent market moves are encouraging and once more demonstrate the value in geographic diversification when investing. With hopes raised that the war in Ukraine may soon come to an end and the European Central Bank expected to cut rates further and faster than the Federal Reserve and Bank of England the fundamental picture is shifting more favourably towards European stocks.

1 GDP international comparisons: Economic indicators - House of Commons Library