Germany Is Europe’s Guiding Light. The U.S. Is the Storm.
The good news for Friedrich Merz, Germany’s chancellor-in-waiting, is that he will need only one coalition partner. Merz’s Christian Democratic Union, or CDU, and the outgoing Social Democratic Party, or SPD, scraped enough seats in the Feb. 23 election for a slender Bundestag majority.
All of the other news is pretty bad. Alternative for Germany, or AfD, a 12-year-old party advocating Germany’s withdrawal from the European Union and euro, and mass “remigration” of foreign-born residents, doubled its vote to 21%. That may not be the ceiling. “Merz’s government is the last chance for the German establishment parties to govern effectively,” says Matt Gertken, geopolitical strategist at BCA Research.
U.S. President Donald Trump is trying to end the Russia-Ukraine war without Europe’s participation (or Ukraine’s) and threatening 25% tariffs on EU imports. “The European Union was formed to screw the United States,” he told reporters on Feb. 27.
Oh, and Germany’s economy shrank over the past two years as a cutoff of cheap Russian gas dovetailed with sputtering demand in China.
But desperate times could push the 69-year-old Merz, a conservative in all senses thus far, to desperate measures for his country and continent. “With a growing understanding that the situation is an emergency, he has the means to take the leadership of Europe,” says Davide Oneglia, director of European and global macro at TS Lombard.
Merz, a staunch pro-American who once chaired the Atlantic Bridge think tank, sounds ready to take up the mantle. Europe “needs to achieve independence from the United States, step by step,” he declared on election night.
Markets look cautiously optimistic. Both the Germany DAX 40 index and the iShares Europe exchange-traded fund kept creeping upward after Germany’s poll, holding double digit gains year to date. The S&P 500 index has risen 1% since Jan. 1.
Merz will have to shake Germany out of its torpor first. “He needs to concentrate on his domestic agenda to gain stature on the European stage,” says Eoin Drea, senior researcher at the Wilfried Martens Centre for European Studies.
While many developed countries are on a debt spree, Germany spends too little, investors say. Berlin needs to uncork up to 3% of gross domestic product annually to make up for lags on rail, digital infrastructure, and other public investments, says Roland Kaloyan, head of European equity strategy at Société Générale.
Merz’s government will have the fiscal space for such a splurge. Germany’s debt-to-GDP ratio is about 62%, whereas France, Italy, and the U.S. are north of 100%. But it will have to release the constitutionally enshrined “debt brake,” which requires a two-thirds vote in the Bundestag. Assuming AfD opposition, the coalition partners will have to rope in deputies from the Greens and The Left, a proto-Communist party that surged into the legislature with 9% of the popular vote.
The Left might approve breaking the brake for infrastructure spending, but not bolstering Germany’s military, another top priority for Merz, Oneglia says. One workaround could be to increase the EU military budget while Berlin looks after its own social needs, he suggests.
Merz brings a diverse résumé and resilient character to the pending political gymnastics. First elected to the Bundestag in 1994, he drifted away from politics after losing a leadership battle to Angela Merkel in 2002. That’s in his favor now, Gertken says. “Merkel’s legacy is in tatters, from appeasement of Russia to being lax on immigration,” he explains.
Merz spent most of this century as a corporate lawyer and serial board member, including stints with Ernst & Young, HSBC, and BlackRock Germany. With Merkel finally out of the picture, he mounted comeback campaigns for the CDU leadership in 2018 and 2021, failing both times. He returns now as the party’s savior. “The CDU was believed to have been crushed in 2021,” Gertken notes.
Whether Merz can evolve from determined plodder to great statesman is just one question hanging over Germany and Europe at this fateful moment. The next year in Ukraine may bring a triumphant Russia to the continent’s doorstep, or massive reconstruction contracts as peace takes hold. Trump may follow through with tariffs or be bought off by European promises to buy U.S. liquefied natural gas and weapons. A reviving China may counterbalance lost U.S. sales, or not.
No wonder opinions are divided on whether European stocks can continue their contrarian rally. SocGen’s Kaloyan doubts it. “We are close to our year-end target unless there is good geopolitical news,” he says.
Gerry Fowler, chief European equity strategist at UBS, thinks the U.S. might get the worst of a trade war with Europe, markets-wise: Trump’s tariffs will hit relatively low-capitalization industrial stocks, while the EU can retaliate against “Mag Seven” tech giants. “Our view is that Europe outperforms the U.S.,” he says.
Markets would prefer no trade war at all, of course. But if it comes, Europe may have found its captain.