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Could an upset for Merkel this weekend slam the brakes on…

Could an upset for Merkel this weekend slam the brakes on investor enthusiasm for European equities?

With just days to go before Germany’s Federal Elections on Sunday 22 September, investors will be watching the outcome closely for any potential impact on the relatively upbeat consensus that has emerged around European equities in recent months.

There is a widely held assumption that greater reforms will follow the elections. These include acceleration of plans to implement some form of European banking union aimed at shoring up confidence in the financial system, and a European budget-discipline pact as proposed by German Chancellor Angela Merkel. There are also expectations that some form of Europe-wide stimulus will ultimately be required to drive the recovery given constrained lending. Recent surveys indicate that asset allocators across the globe have been raising their weightings to the region.

Bestinvest has been highlighting the attractiveness of European equities on a valuation basis since summer 2012 and European stocks have rallied significantly over the last year, with the FTSE Europe ex UK index rising 26% on a total return basis in the 12 months to end August. Although European equities are now trading at valuations more in-line with their longer-term trend, they remain relatively cheap compared to US equities. European equities are on a 12-month forward PE ratio of 13x earnings compared to US stocks on 14.8x.


Merkel is ahead, but the coalition continuity is not assured


The risk now is that this optimism could crumble should the centre-right coalition led by Angela Merkel not prevail in this weekend’s German elections.

While most polls put her Christian Democrat party and its sister party the CSU comfortably ahead of her main rivals the Social Democrats, a near wipe out of her centrist coalition allies, the Free Democrats, in the Bavarian regional elections at the weekend – polling just 3% - would dramatically derail the status quo if repeated on Sunday.

Under German election law, a party must gain at least 5% of the vote to win seats in the Bundestag. While the Free Democrats are teetering around this level in national opinion polls, the anti-EU Alternative for Germany Party (AFD) has seen a surge in support since the Greek bailout reared its head again in August. Polls suggest the AFD is closing in on the 5% threshold.

Should Merkel have to enter coalition talks with her Social Democrat rival, Peer Steinbrueck, it would be an uncomfortable alliance. Steinbrueck favours tax rises at home and a less vigorous insistence on austerity abroad. Under Chancellor Angela Merkel’s leadership, Germany has resolutely insisted that bailouts of indebted south European countries are tied to doses of austerity.

Such a scenario of wounded German leadership might quickly recalibrate investors’ minds back to the fundamental challenges facing the Eurozone, many of which remain on hold but are not yet fully resolved.

Even once Germany has got through the hurdle of its elections, a further potential banana skin awaits with a constitutional ruling expected on the legality under German law of the European Stability Mechanism and the ECB's Outright Monetary Transaction programme.


We favour European funds with exposure to global businesses


Given the continued attractions of European equities on a relative valuation basis to the US, but potential for bullish assumptions on politically-led reforms to falter, we favour funds with a high weighting to core-European domiciled global brands, rather than cyclical companies focused on domestic European economies. Funds we favour include Threadneedle European Select, Henderson European Focus and Schroder European Alpha Plus. Such funds have had delivered lower returns over the last year than those focused on more domestically-biased companies, but we believe they will be more robust should choppier waters return.

The value of your investment can go down as well as up, and you can get back less than you originally invested.

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