By Mike Dolan
LONDON Jan 18 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
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
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
"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
"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,
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."