INVESTMENT FOCUS-Once wary markets warm to Merkel status quo
LONDON Jan 18 (Reuters) - As the euro crisis raged at its peak just over a year ago, few global investors reckoned Angela Merkel's re-election as German Chancellor this year was likely or even desirable.
Now they appear to be assuming both - thanks partly to her gaffe-prone Social Democrat opponent but perhaps as much or more so to European Central Bank chief Mario Draghi and his success in stabilising the teetering currency bloc last year.
As Sunday's state elections in Lower Saxony give investors an early glimpse of how September's federal elections may play out, Merkel has a commanding poll lead over Peer Steinbrueck as Germany's favoured next Chancellor.
The constellation of coalition government she will be able to form is far more in question, but investment strategists see status quo in the chancellery at least as the best bet for sustained rehabilitation of the battered euro bloc, and, by extension, economic stabilisation home and abroad.
Sunday will show whether Merkel's Christian Democrats (CDU) and Free Democrat (FDP) allies - now neck and neck in opinion polls with the centre-left pairing of Social Democrats and Greens - can hold the country's fourth most populous state and herald a turnaround after drubbings in 12 regional elections since 2009.
For overseas money managers who claim to see few major differences between the two sides on critical euro or domestic economic policies, the familiarity of Merkel's existing government and her crisis management now seems to offer greater comfort.
And yet this has only really taken shape since last July, when Draghi's "whatever it takes" pledge to defend the euro defused the explosive sovereign debt crisis.
Back in 2011, investors fretted about whether Merkel and her coalition had the will, the plan or the public backing to keep supporting Greece and other ailing euro governments while staying committed to the euro via deeper integration.
As markets dumped the problem debtors of the euro zone periphery and the prospect loomed of ever more bailouts and deepening recession, Merkel's domestic popularity reached a similarly low ebb.
But these have reinforced each other on the upside too.
Euro stabilisation - which has almost halved Italian and Spanish borrowing costs from their respective crisis peaks over the past 16 months - has fed Merkel's domestic popularity and the rebound in her popularity now looks as if it may reinforce the euro recovery.
And despite the recent slowing, the German economy itself remains impressively near full employment while German stock prices gained a whopping 30 percent in 2012.
"To simplify it a lot, Merkel's popularity has been inversely correlated with the yields on peripheral euro bonds," said Alex Godwin, Global Head of Asset Allocation at Citi Private Bank in London.
"Arguably, the biggest supporter of Merkel's re-election has been Mario Draghi. By staving off a disaster and stabilising the situation, he has made the last two years of euro zone politics look much more successful than it seemed at the time."
Godwin said what's become clearer to outside observers over the past year - and perhaps to many German politicians too - is just how much German public opinion still favours holding the euro together, for all its wariness about endless bailouts.
"Germans seemed genuinely scared of the prospect of a Greek exit or euro collapse," he said. "And anti-euro rhetoric or bailout opposition has never really chimed with the electorate. So Merkel's 'carrot-and-stick' approach is the balance that most inside and outside the country are happiest with."
Franz Wenzel, chief investment strategist at AXA Investment Managers in Paris, feels the full-term review of Merkel outside the country very much tallies with her surging poll ratings.
"Investors would now be worried about a government without Merkel," he said. "She has done a fairly good job in a very difficult period, she's been a guarantor of the euro zone, a safe haven in a turbulent environment, and the German economy in terms of key employment metrics still looks fine."
Others are more worried about coalition maths, however, and the implications for a new Merkel-led federal government later this year. This is why Sunday's regional poll may act as a bellwether.
"If she did badly this weekend, then it could surprise markets and unnerve people about how the smaller parts swing the next government," said Peter Westaway, chief European economist at fund manager Vanguard, adding that this would affect perceptions of policy timing and volatility rather than basic assumptions about European policy.
If the SPD and Greens do take Lower Saxony, some analysts say their increased strength in Germany's upper house, the Bundesrat, could frustrate and block more legislative proposals. While some reckon this is already possible anyway, Commerzbank analysts say a formal blocking majority could give the impression of a "lame duck" federal government before September.
To be sure, strategists say a national SDP/Green government later this year could favour euro integration even more than the CDU, at least partly offsetting market concerns about their emphasis on stricter regulation of banks and higher wealth taxes.
"From a euro crisis perspective, it's difficult to imagine an event that could drastically change things in an anti-euro way," said Kevin Gardiner, head of investment strategy EMEA, Barclays Wealth.
Yet the fate of key Merkel allies and euro bailout sceptics FDP may be a more potent signal on Sunday, raising serious questions about whether they can command the necessary 5 percent minimum to enter the Bundestag later this year. If they can't, it would limit Merkel's coalition options and threaten her bid for the top job in the absence of a grand coalition.
Bernhard Speyer, joint head of Deutsche Bank Research in Frankfurt, said a Merkel re-election in some format is clearly now what the electorate and financial markets seem most comfortable with but he reckons this Sunday's vote could raise questions about the outcome even if her CDU is victorious.
"If the SPD get a real drubbing, it could prompt an internal debate on whether they have the right candidate for Chancellor and a change of name at this stage would be a wild card."
The other risk is that Merkel has a lot of difficulty putting together a coalition and faces a more antagonistic SPD even in a 'grand coalition', Speyer said.
"That could mean a prolonged period of introspection, which is always a distraction from responsibilities abroad."