German elections: reform needed, but what’s feasible?

By Irene Lauro, European Economist at Schroders; James Bilson, Fixed Income Strategist at Schroders and Martin Skanberg Fund Manager, European Equities at Schroders

The outcome of Germany’s elections on 23 February was largely as expected. Friedrich Merz’s Christian Democrats (CDU) emerged as the largest party and the far-right Alternative for Germany (AfD) making gains.

Negotiations to form a governing coalition will now begin. Merz has signalled an intention to form a government by Easter (20 April). A coalition between the CDU and the Social Democrats (SPD) appears the most likely scenario.

However, while such a coalition would constitute a workable government, it would not have the two-thirds majority required to make changes to the constitution. That complicates any plan to reform the debt brake, which was a key focus in the run-up to the elections. Germany’s debt brake is a constitutional rule that limits government borrowing and keeps the structural deficit below 0.35% of GDP.

Economic view: Irene Lauro, European Economist

The economic implications of the election will largely not be felt until 2026. This is because it will take some time to form a government and then agree a budget.

Merz has signalled his willingness to examine reform of the debt brake but, given the make-up of parliament, this looks complicated. The AfD and Die Linke (far left) form a blocking minority.

Any increased fiscal spending in Germany would be focused on defence, given the geopolitical backdrop. President Trump has been clear in his view that Europe needs to spend more on its own defence. Germany currently spends c.1.4% of GDP annually on defence and this would need to rise to 3.5% if Germany were not to be reliant on US help.

However, increased military spending would not on its own provide a boost for the domestic economy. Much defence procurement would continue to be from foreign, mainly US, companies. Increasing purchases of US weapons could also be used as a negotiating tool in trade discussions with President Trump.

After defence, the next key electoral priority is to reduce energy costs. These spiked in the wake of Russia’s invasion of Ukraine. The new government may look to reduce energy taxes and to invest in renewable grids and infrastructure.

Another policy promise is to lower both corporate taxes and income taxes. This would be well-received by both corporates and consumers and could potentially provide a lift for equities. However, it remains to be seen how such policies would be funded.

A key problem for the German economy has been lack of investment and Germany has underperformed the rest of Europe on this front since the pandemic (see chart below). German companies have been investing abroad but not at home, citing high energy and labour costs, and lengthy approval processes.

While reform of the debt brake has been the dominant pre-election issue, there are supply side challenges that need tackling. But protracted negotiations are likely to be required.

Fixed income view: James Bilson, Fixed Income Strategist

The key factor for fixed income markets heading into Sunday’s vote was whether there would be a two-thirds majority in the new Bundestag to reform the debt brake. A change here would open the way to more fiscal easing than is currently possible. This would be a catalyst for a significant repricing of German Bunds.

However, it appears a sufficient majority has not been reached, which explains the relatively muted market reaction to the result.

Nonetheless, while the German election is very important, we should not lose sight of a broader shift in the geopolitical landscape within Europe. The need to act much more swiftly and independently to bolster its own defence capabilities, given changing US priorities. It is likely to be a major theme over the months and years to come.

From a fixed income point of view, we see this as likely to lead to greater fiscal spending (and deficits) on defence in upcoming years, even if not immediately. While the intricacies of how this is financed will take time to negotiate – at a national level, by repurposing existing common EU funds, or creating a new common instrument – the trend seems clear.

In our view, while the German election has removed an immediate catalyst for fiscal easing, the market will likely continue to reprice the medium-term trajectory of looser fiscal policy in Europe. Since we believe the near-term impact of these dynamics on European Central Bank policymaking will be limited, we expect fiscal changes to have more impact on longer-dated than shorter dated bond yields in Europe, with longer-dated yields moving higher.

Moreover, while the spread (or difference) between US Treasuries and German Bunds reflects various factors, we think the fiscal divergence of recent years – with much larger deficits in the US than Europe – has been a key driver. If this fiscal divergence turns towards fiscal convergence over the medium-term, we see the gap between US Treasury and German Bunds closing.

Equities view: Martin Skanberg, Fund Manager, European Equities

There has been consensus building for some time that Germany needs reforms to increase its competitiveness. The specifics of this will take some time to be negotiated. Merz’s CDU has indicated an intention to drive through reforms and pursue a pro-growth agenda, which should be good for German corporates.

German equities had been underperforming the rest of Europe in recent years but that pattern changed in late 2024. The stronger performance of German equities has continued into 2025.

Past performance is not a guide to the future and may not be repeated.

Hopes of reform could lead to an increase in positive sentiment towards German equities, and Europe more broadly. Measures such as tax cuts could improve corporate profitability as well as boosting consumer spending power.

The significant step-up in European defence ambitions following the Munich security conference is set to benefit arms manufacturers in Germany and Europe. This could help to alleviate weakness seen in other parts of the German economy.

That said, economies are not stock markets and vice versa. As is the case for many stock market indices, the German benchmark is highly concentrated. Two companies – SAP and Siemens – make up 28% of the MSCI Germany index (source: MSCI, 31 January 2025). Overall index performance is therefore highly reliant on the fortunes of a few large companies. This highlights the importance of a stock picking approach that can unearth the best opportunities not just the largest ones.

Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only. It’s not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.