German election: Potential Jamaica coalition bodes challenges for Europe

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The German federal election saw the Christian Democrats emerging as the biggest party, with Angela Merkel on track for her fourth term as chancellor.

At the same time, both Christian Democrats and Social Democrats sustained major losses as the extreme right AfD entered parliament for the first time in post-war history.

Faced with the worst election outcome since the end of World War II, the Social Democrats, who previously were in a grand coalition with the Conservative, announced that they are no longer willing to govern.

This leaves a coalition between Conservatives, the liberal-right wing FDP and the Green party, a so-called “Jamaica Coalition” as the most likely scenario, according to Björn Jesch, head of portfolio management at Union Investment. He believes that such a coalition might even offer opportunities for further economic reforms. “For markets, this means wait and see. We don’t anticipate significant market movements in the short-term” he adds.

Jaisal Pastakia, investment manager at Heartwood Investment Management, stresses the ideological divergence between the Green party and the euro sceptical FDP as a potential challenge for Europe.  “The FDP’s Lindner has made it clear that he is not a fan of Macron’s vision of Europe. It leaves more uncertainty about how Europe moves forward towards its integrationist vision” he warns.

Christophe Bernard chief strategist at Vontobel, believes that due to this divergence, a Jamaica coalition is unlikely: “the probability of a coalition with these two junior partners is still quite small as it would be prone to a break-up. While the FDP wants to cut taxes substantially, decrease redistribution and is opposed to closer integration in Europe (and the euro zone), the Greens hold diametrically opposing views, e.g. on European integration. On top of that, the FDP is hardly willing to invest  heavily into a stronger environmental policy – a key demand of the Greens.”

Either way, Ricardo Garcia and Paula Patzelt, economists at UBS predict that it may take longer than expected to form a new government.  “Following the SPD’s decision to go into opposition, Angela Merkel will have to find a way to make a Jamaica coalition (CDU/CSU/FDP/Greens) work. However, Merkel will try to convince the SPD to continue with a grand coalition, so that an SPD comeback cannot be excluded. Given the complexity of a Jamaica coalition, negotiations could take 3-6 months. Our best estimate is that the new government will be in place in the first quarter of 2018.

Wolfgang Bauer, bond fund manager at M&G Investments suggests that despite gaining a fourth term in government, Ms Merkel may have won a pyrrhic victory: “Whether there is going to be a grand or a Jamaica coalition in the end, negotiations are going to be tough either way and might drag on for a while. This clearly weakens Merkel’s position both inside Germany and abroad. She might get challenged by French president Emmanuel Macron for the unofficial leadership role within the EU. If he is able to seize the moment, this would make Eurozone debt mutualisation and the creation of a European finance minister more likely, at least in the medium term. Merkel’s rumoured plan to install Jens Weidmann, the current President of the Bundesbank, as new ECB President after Draghi’s term ends in 2019, seems less realistic today. This increases the odds of a continuation of the ECB’s expansive policy stance.”

The challenges are even more pressing on a national level, as Bauer highlights: “One of the most striking election results is certainly the strong performance of the right-wing nationalist AfD (12.6%). Not only is the party entering the German Bundestag for the first time but the AfD is going to become the third largest faction in parliament. If the grand coalition is continued – which can’t be ruled out entirely at this point – the AfD would de facto become the opposition leader.”