German elections: A new coalition, not nationalism, is the story

After a year of disruptive elections and referendums in Europe and the U.S., the populism wave finally reached the shores of Germany. In the Sunday election, the nationalist, anti-immigrant Alternative für Deutschland (AfD) party nearly tripled its share of the vote to 13 percent, making it the third-strongest party in Germany’s Bundestag.      

The ruling Grand Coalition of the center-right Christian Democratic Union (CDU) and the center-left Social Democratic Party (SPD) lost a massive 14 percentage points, clearly signaling that German voters want change. While the AfD got most of the attention, three other smaller parties — the Greens, the pro-business Free Democratic Party (FDP) and the left-wing Die Linke — also increased their tallies.

{mosads}Despite the losses, Angela Merkel’s CDU remains the strongest political force in Germany, with Merkel set to start her fourth term as chancellor. Before the night was over, Merkel’s previous coalition partner, the SPD, which suffered even worse losses, declared itself unavailable for talks and instead plans to lead the opposition in Parliament.

While technically possible — CDU and SPD would still have a 44-seat majority — it’s inconceivable another grand coalition could claim to have a mandate to govern, and none of the parties want new elections.  

That leaves only one viable combination to form a majority government: the “Jamaica” coalition — so called because the party colors of black (for the CDU), yellow (for the FDP) and green (for the Greens) match those of the Jamaican flag.

Such a coalition has already governed in three of Germany’s 16 states. Hence, members of each party have managed to find common ground before. Differences on the national level, however, are wider.

While the period of interparty negotiations may increase uncertainty and weigh on financial markets, the prospect of this new coalition could also bring a fresh approach to German and European reforms. The FDP is likely to demand the finance ministry for one of its members.

That would mean an end to the German austerity personified by current CDU Minister Wolfgang Schäuble. The FDP would want to use Germany’s excellent budgetary position to cut taxes and stimulate demand, while the Greens would likely seek to ensure that tax relief will not just benefit businesses and the wealthy but also provide a strong middle-class stimulus.

The new coalition would likely remain decidedly pro-European and broadly supportive of French President Macron’s proposals for greater fiscal integration. A Merkel-led government of any coalition will not support a simple redistributive increase in eurozone fiscal spending.

Yet, a possible next step is greater coordination of fiscal policy, subject to strict budgetary rules under existing institutions, such as the European Stability Mechanism (ESM), which oversees the bailout programs. This coalition could also lead to increased spending for security and policing, which the CDU will demand, and provide more financial support to integrate immigrants, a Green priority. Such policies would likely deliver noticeable growth stimulus in the coming years.

To be sure, the results of the German elections have shaken the country’s political establishment. But once the dust settles, only one coalition seems viable, which should force the three parties involved to succeed, even if it takes three or four months to form an agreement.

In the short term, the risk of a greater political crisis, should coalition negotiations fail and new elections become necessary, may weigh on market sentiment. However, the potential policy shifts of a Jamaica coalition should be strongly pro-growth and pro-European reform.

Angela Merkel is looking to move the EU forward, and a more unified fiscal policy is the logical next step. Replacing Schäuble with a more pro-tax-cut FDP minister would boost growth in Germany and accelerate the economic rebound in Europe.

So, this new government has the potential to reboot Germany after four years of economic prosperity, but a distinct lack of domestic reform progress. Despite losing ground, Angela Merkel may very well end her political career in four years on a high.

Markus Schomer is the chief economist for PineBridge Investments, a global asset manager with experience in emerging and developed markets. Prior to joining PineBridge, Schomer was a fixed income analyst at Commerzbank in Frankfurt, Germany.