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Germany holds snap poll on Sunday

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Debt brake, weak economy, parliament seat numbers in focus

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Defence spending set for a boost

By Samuel Indyk, Greta Rosen Fondahn, Stefano Rebaudo

LONDON, Feb 19 (Reuters) - Sunday's German election may

result in a conservative-led coalition government that faces

pressure for much-needed change to revive the stagnant economy -

and moves to block reform by populist parties if they do well.

Europe's largest economy could face months of uncertainty. Polls

show the conservative CDU/CSU bloc led by Friedrich Merz is

tipped as the winner but will need a partner - or possibly two -

to govern.

Whether those in power can reform the country's self-imposed

debt brake to allow more spending that lifts economic growth is

in focus.

Here are five key questions for financial markets.

1/ What will investors be looking out for first?

First, how quickly a government could possibly be formed

and, second, whether there is a two-thirds majority of parties

entering parliament that support fiscal reform.

"If there are long (coalition) discussions or three parties

involved, that would complicate things," said Simon Keller,

equity research analyst at Hauck Aufhäuser Investment Banking

(HAIB).

"It would be easiest if both the CDU/CSU and (centre-left

Social Democrats) SPD have enough votes to go into a

coalition."

Should a one-third blocking minority of populist parties,

including the right-wing AfD and left-wing BSW, enter

parliament, that could scupper hopes for large-scale fiscal

reform, even if they are not part of the administration, which

would unsettle markets.

2/ Will the election bring debt brake reform?

Markets are unconvinced that a radical reform of the "debt

brake", which tightly limits spending, will happen, although a

modest loosening of fiscal policy is expected.

Analysts say the constitutional debt brake has prevented

governments from making vital investments, for instance in

infrastructure, to overhaul an economy that shrank for a second

straight year in 2024.

PGIM Fixed Income chief European economist Katharine Neiss

said a slight tweak that allows a little more discretion on

spending could be expected.

"But that said, we can have a high conviction that we will

see more fiscal spending and that's obviously good news at the

margin," Neiss added.

3/ Where does that leave the euro and bonds?

The euro is expected to benefit from any increase in

government spending that boosts the economic outlook.

Trading near $1.0460, the euro has been whipped

around by fears of U.S. tariffs and hopes for a Ukraine-Russia

ceasefire.

"A grand coalition (CDU/CSU and SPD), alongside a two-thirds

majority needed for the debt-brake reforms, would likely be

euro-positive," Morgan Stanley said.

A rise in fiscal spending meanwhile could increase the

supply of German government bonds, thereby lifting yields

.

Bond yields across Europe have also risen in anticipation of

higher defence spending.

Citi added that peripheral bond markets such as Italy could

also draw support if a CDU-led mainstream majority coalition

emerges, as any steps to boost Germany's economy are also viewed

positively for the region as a whole.

4/ What about equities?

The election could boost German economy-exposed stocks if

corporate tax cuts and stronger growth follow.

Note, the large-cap, more global DAX index is near

record highs, while mid- and small-caps have

lagged as companies more exposed to weak domestic growth

underperform.

"Contrary to most recent elections in Europe, the German one

is more a positive tail risk than a negative one," said

Barclays' head of European equity strategy Emmanuel Cau.

Investors may be front-running the results. Weekly inflows

into Europe excluding UK equities hit their highest in two years

in the week to Wednesday, Barclays said, citing EPFR data.

5/ Will more be spent on defence?

That's looking likely as Washington pressures Europe to ramp up

defence spending ahead of U.S./Russia talks on a possible

Ukraine peace deal.

German arms maker Rheinmetall on Monday surged as much

as 11% to record highs.

The CDU/CSU believes NATO's defence spending target of 2% of

GDP is a minimum. Likely coalition partners - the SPD, Greens

and/or FDP - favour at least meeting NATO spending targets.

"The debt brake will be reworked, not for a massive stimulus

package, but to accomplish higher defence spending, for

example," HAIB's Keller said.

Signs that Brussels could make it easier for countries to

increase defence budgets outside of usual deficit limits have

also lifted defence stocks RENK Group ( RNKGF ) and Hensoldt

.