EUROPEAN ECONOMY
Macroscope
by

Never mind Trump, Merkel’s exit is the big political risk

PUBLISHED : Thursday, 01 September, 2016, 4:47pm
UPDATED : Monday, 19 September, 2016, 3:33pm

For the next two months, all eyes will be on the US presidential election.

While Hillary Clinton, the candidate of the Democratic Party, is expected to win the contest, which takes place on November 8, her Republican opponent, the unabashedly populist Donald Trump, is only six points behind his adversary and could still win the election.

Yet while US politics will dominate the headlines for the next 10 weeks, investors would be well advised to pay close attention to the other big political risk hanging over financial markets: the possibility that Angela Merkel, Germany’s long-serving chancellor and the most powerful figure in European politics, may decide to step down ahead of a crucial parliamentary election in autumn 2017.

On Sunday, Merkel’s party, the ruling Christian Democratic Union, is expected to perform poorly in a closely watched regional election in the chancellor’s home state of Mecklenburg-Vorpommern.

The CDU’s woes stem entirely from Merkel’s highly controversial decision last year to throw open Germany’s borders to more than a million mainly Muslim refugees and subsequently fail to push through an equally contentious plan to make each country in the European Union take a quota of the migrants.

A fierce domestic backlash against Merkel’s open-door refugee policy has been fuelled by two terror attacks in Germany this summer, both of which were carried out by refugees linked to the Islamic State militant group.

Nearly two-thirds of Germans disapprove of Merkel’s refugee policy while the chancellor’s approval rating has plummeted from more than 70 per cent at the beginning of last year to less than 50 per cent, according to an opinion poll in early August.

The greatest beneficiary of mounting concern about Germany’s ability to absorb and integrate tens of thousands of migrants is the populist Alternative for Germany (AfD) party, which has established itself as a powerful force in German politics. The party won nearly a quarter of the vote in a regional election in Saxony-Anhalt in March and, even more remarkably, is neck and neck in the polls with the CDU in the run-up to Sunday’s election in Mecklenburg-Vorpommern.

While Merkel declared her candidacy for chancellor two years before Germany’s last parliamentary election in 2013, she has yet to announce whether she will run in next year’s federal election. This is fuelling speculation about whether she will resign or, if she does decide to run, whether she will have the crucial support of the CDU’s Bavarian sister party, the Christian Social Union, which has been highly critical of Merkel’s refugee policy.

A politically weakened Merkel not only plunges German politics into a period of deep uncertainty, it increases the scope for further turmoil in the EU, already struggling to cope with the refugee crisis, the shock decision of Britain to leave the bloc and, crucially, persistent tensions in the vulnerable euro zone.

Make no mistake, Merkel’s political woes are bad news for Europe and could not come at a worse time.

The immediate threat is the surge in the popularity of the AfD at a time when many other countries in Europe, in particular France and Italy, are steadily succumbing to populism and nationalism.

A more populist and eurosceptic Germany poses a major threat to the process of European integration

Not only is the AfD highly critical of Merkel’s refugee policy, it is also strongly opposed to the ultra-loose monetary policies of the European Central Bank – which holds its next policy meeting on September 8 and is under pressure to provide more stimulus – which are deeply unpopular in Germany, with many politicians accusing the ECB of “expropriating” the country’s savers by imposing negative interest rates.

A more populist and eurosceptic Germany poses a major threat to the process of European integration, notably efforts to shore up the EU’s shaky monetary union through more pooling of sovereignty – and financial risks – among member states.

Merkel’s leadership in Europe (together with the crucial support from the ECB) has just about kept the euro zone together over the past five years. Even if she does decide to run for chancellor again – the most likely scenario – the refugee crisis has undermined her authority at home and abroad.

After four years of relative calm in euro-zone bond markets, investors are now faced with rapidly diminishing returns from the ECB’s monetary policies and a much more politically unstable Europe.

Trump may be the centre of attention right now, but German politics is the bigger worry.

Nicholas Spiro is a partner with Lauressa Advisory