Markets need convincing that German election will bring spending boost

By Yoruk Bahceli, Emma-Victoria Farr and Samuel Indyk

LONDON/FRANKFURT (Reuters) - As Germany heads to the polls next week, the message from investors is clear: it is the one big economy with room to spend more to boost growth and it won't be punished by financial markets if it chooses to do so.

For now they are unconvinced that Germany's next governing coalition - whichever parties it contains - will take a radical step on spending and borrowing.

But the case for change is strong.

Germany's once-mighty economy has flatlined since 2019, while the rest of the euro area has grown by 5%, and the U.S. 11%, Goldman Sachs estimates.

However, it is also the only G7 economy with debt well under 100% of output and, in contrast to concerns about high debt in the U.S., Britain and France, investors want to see Germany borrow more to boost its growth potential.

Markets are watching to see if Germany will loosen a 'debt brake' rule that has stamped out new borrowing, an even more pressing concern now that U.S. tariffs threaten to hurt its ailing economy further and it needs to raise defense spending.

"If there's one country where actually, potentially you could (raise borrowing), that would be Germany," said Nicola Mai, who leads sovereign credit research for bond giant PIMCO in Europe, referring to the debt brake as a 'straightjacket.'

Until Germany tackles its deep-seated problems, especially deteriorating competitiveness, questions about the status of the former powerhouse will linger.

So, while political uncertainty could weigh in the short term, a battered euro and long-lagging European stocks have much to gain from a meaningful rise in spending.

That doesn't seem to be on the cards, with just under two thirds of investors in a poll BofA published in January expecting only a minor debt brake relaxation.

Mai, who also doesn't expect a change that would be a "huge deal", said PIMCO favours taking interest rate risk in European bonds, betting rate cuts, not spending, will drive markets.

MUCH TO GAIN

Conservative leader Friedrich Merz, expected to head the next government, has shown openness to limited debt brake reform.

Expectations are muted, with European Union deficit limits also constraining spending potential.

The debt brake currently constrains structural deficits to 0.35% of output.

A December poll by Citi showed clients saw the ceiling rising to 1% as the most likely outcome. That's likely not enough considering that just making up the last decade's underinvestment requires investments of around 1.5% of output annually for 10 years, ING estimates.

Danske Bank reckons debt brake reform will raise growth by around 0.2 percentage points annually in the coming years.

The risk of no reform at all is real if the far-right Alternative for Germany and the neoliberal Free Democrats gain enough seats to block a constitutional change. Reforming the debt brake or another option - launching special funds to raise spending outside the brake - requires a two-thirds parliamentary majority.

German 10-year government bond yields exceeded the rate on interest rate swaps for the first time last year , partly on expectations of higher issuance after its government collapsed in November.

But bond yields have barely risen since then, a sign that higher spending is seen as manageable.

Elsewhere, the question is whether spending rises enough to halt European underperformance.

The euro is down 17% from a peak $1.25 in 2018, and neared $1 earlier in February.

Societe Generale's head of FX strategy Kit Juckes said European policy choices promoting less growth than in the U.S, which has spent much more, have been one key reason behind that fall, with Germany a big part of that.

He said he did not see enough signs of a policy shift to change his $1.04 euro target for the first half of this year.

Andreas Koenig, head of global FX at Europe's largest asset manager Amundi, agreed, continuing to favour the dollar.

RE-RATING?

At first sight German stocks look to have been spared with the blue-chip DAX index's 45% return beating U.S. stocks over the last three years. Yet relative to forward earnings, it trades at a 38% discount to the S&P 500.

Driven by international earnings, the DAX masks the pain in companies with higher home exposure. Mid-cap and small-cap stocks have lost 18% and 2% over that time period. Carmakers, once central to Germany’s powerhouse, have slid 35%.

Rameez Sadikot, portfolio manager at Antipodes Partners, said a new government could potentially lead to a "multiple re-rating" in European equities if it started to ease concerns around low productivity.

But for now, he was "cautiously optimistic", citing the risk of gridlock.

Dealmakers would also welcome more spending, given Germany has seen the lowest volume of mergers and acquisitions year-to-date since before 2010, according to Dealogic.

They are in 'wait and see' mode for now, according to bankers and lawyers, although Alexander Kutsch, managing partner at advisory firm Roedl & Partner said debt brake reform would support activity.

The question remains whether a new government can address Germany's key structural issue, a decline in competitiveness, quickly.

Fidelity International's global head of macro and strategic asset allocation Salman Ahmed said it would take much more spending than expected to change Germany's economic model, adding he saw "no consensus yet" to improve competitiveness.

(Reporting by Yoruk Bahceli and Samuel Indyk in London and Emma-Victoria Farr in Frankfurt; editing by Dhara Ranasinghe and Toby Chopra)