By Brian Swint

Germany heads to the polls this weekend and the election may bring about big changes that could give the country's red-hot stock market an extra leg up.

While the immediate outcome may not be decisive or lead to any short-term boost for the economy, it could be the beginning of the solutions to Germany's wide-ranging problems.

Europe's largest economy finds itself in an odd juxtaposition. Politically and economically, it's in crisis -- the election is coming months earlier than it had to after the current government collapsed over disagreements about the budget. The country hasn't seen any meaningful growth since the end of the Covid-19 pandemic. And yet the blue-chip DAX index is booming, up 12% this year and hitting a record high on Feb. 19.

"While the upcoming German elections may not deliver sweeping policy changes, the resulting policy clarity could serve as a much-needed tailwind for German equities," said Michael Field, an equity strategist at Morningstar. "Autos, defense, and utilities are poised to be impacted from targeted support and renewed investor confidence, creating potential for long-term growth."

Right-Wing Risk

This weekend the political problems will start to be fixed. The voting process is very different from the U.S. presidential system. It relies on the parties with the most representatives working together to form a functioning administration.

Opinion polls show that Germany will almost certainly get a new chancellor to replace Olaf Scholz, with the center-right CDU Party well ahead in the polls. But it will probably have to work with its traditional center-left foe, Scholz's SPD, to form a government.

There could be surprises -- CDU leader Friedrich Merz, the likely next chancellor, may have to bring in a third party such as the Greens to secure a robust majority in the Bundestag. The more would not be the merrier, because the more parties there are in negotiations, the harder it is to reach agreement. That was one of the problems with the three-party coalition that collapsed under Scholz.

The biggest risk is that the far-right AfD Party performs well enough to be able to block the new agenda. Polls show it's likely to become the second-biggest group in the parliament but all the others have said they won't work with the party, so it's very unlikely to be a part of the next government. Still, if the AfD wins enough support, it could make things difficult for the new administration.

Trade Troubles

In any case, the talks to form the coalition are likely to take months, so little will be resolved even once the votes are counted. The bigger question is how the new government can help the economy.

Here, Germany has some very big problems. For more than a decade, it has relied on cheap energy from Russia and unfettered trade with China for its prosperity. Both of those pillars have collapsed in the past few years, with Russian natural gas cut off after its invasion of Ukraine and Chinese demand dented by the country's extended property slump.

Add to that an aging population, with a shrinking workforce and growing number of dependent elderly. Then throw in the struggling manufacturing and automobiles sectors -- traditional German powerhouses. What's more, U.S. President Donald Trump's tariffs on imports will be damaging to countries like Germany that rely heavily on global trade. There are no quick fixes to nation's biggest issues.

"Expectations for German growth in 2025 have continued to edge lower," said Andrzej Szczepaniak, an economist at Nomura. "Confidence is remarkably below prepandemic levels across households, investors, and corporates, and is unlikely to improve noticeably in the near-term, particularly in light of U.S. policies that could hit Germany more acutely than its European neighbors."

Impressive Index

However, there is plenty of low-hanging fruit the next government could reach for that would help. The biggest issue is the so-called debt brake, a constitutional requirement that budget deficits be kept small. Merz has signaled a willingness to either reform the law or figure out some kind of workaround that would allow the government to unleash spending on roads, railways, and defense -- the latter is particularly urgent given the war in Ukraine.

A CDU-led coalition would also be likely to lower taxes and work on ways to create cheaper energy, according to Maximilian Uleer, a strategist at Deutsche Bank in Frankfurt. And that would help the DAX even more.

Uleer explains the index's recent success as a function of its separation from Germany's domestic economy. He reckons that companies on the DAX make 80% of their revenue outside of the country -- and the U.S. accounts for 24% of revenue. And even though traditionally strong sectors such as automobiles have been doing poorly, they make up less of the DAX than they used to. The biggest components of the index are now technology, industrials, and financials.

So the question for investors in the German election this weekend is whether the result will produce a government willing and able to do all it can to reverse the country's economic malaise. It won't be easy, but the benefits for German stocks will be great if it happens.

Write to Brian Swint at brian.swint@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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February 21, 2025 10:23 ET (15:23 GMT)

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