Merlin Weekly Macro: Germany’s political polarisation

Prefer audio? Listen to the recorded version below.

Another week rolling with the punches as markets continue their propensity to react impulsively (more accurately ‘compulsively’) to every utterance and nuance emitted by Donald Trump or the Iranian leadership in their enduring military stand-off.

For investors it is no longer just about the freedom of navigation in the Hormuz and Bab al-Mandab straits; the epicentre of global market concern today is diesel, the smelly, toxic essential global commodity driving transport and industry that is already under strain thanks to significant disruption to supply because of both the Gulf and Ukrainian wars. Donald Trump says he supports the idea of a 90-day US export ban for diesel to try to lower US domestic pump prices ahead of the mid-terms; “Diesel!” was his exasperated exclamation this week at the UN to President Zelensky (loosely translated as, “Stop bombing Russia’s refineries, Volodymyr. Six dollars a gallon is killing me!”).

Without it yet being policy, the mere suggestion of an embargo sent global wholesale prices sharply upwards raising longer duration inflation concerns. Markets reacted by pushing the US 10-Year Treasury yield through the psychological barrier of 5% to 5.16% at the time of writing; relishing a punch-up, US Treasury Secretary Scott Bessant’s recent challenge to the markets to “bring it on” has been taken up with alacrity; given he threw down the gauntlet when the yield was under 4.8%, so far he’s losing despite deploying billions of dollars in its defence. In the UK, we tested new recent highs with 5.38% for the 10-Year gilt, while Japan’s equivalent has pushed through 3% to 3.08%, the most expensive since the late 1990s. Remember, in the fixed income world, bond yields and bond prices move in opposite but not equal directions.

“Donner und Blitzen!”

If bond markets are wearing the weight of the world on their shoulders, in another sphere the German political establishment has just been struck by a thunderbolt. The principal focus of today’s column is the ramifications of the seemingly inexorable polarisation of German politics, especially to the right-wing of the spectrum.

This was never supposed to happen. There was never again supposed to be anything that came close to replicating the type of anti-Bolshevik nationalism that first appeared in the 1920s out of Germany’s immiseration in the wake of The Great War. It was from among the ashes of the punishment meted out to Germany by the League of Nations, and as a direct rejection from within Germany of revolutionary communism which had been sweeping Europe, that the seeds of National Socialism germinated and quickly took root. Following World War Two, the “firewall” agreement between the principal centrist parties in the newly constituted West German Bundestag said that none would agree to work in coalition with any far-right party at any level of government. It was designed specifically to keep any such party from directly wielding or influencing political power.

Reaction to the Right wing: fatally flawed thinking

Those who enjoy war films (for our international readers, war films are an enduring preoccupation in the UK: read into that what you will) may remember the famous scene in “A Bridge Too Far” (Operation “Market Garden”, the doomed inter-allied airborne and ground assault on German-occupied Holland in September 1944, which its progenitor, British Field Marshal Sir Bernard Montgomery, hoped would end the war by Christmas). As the plan was being outlined, it was the irascible and unflinching General Sosabowski (played by Gene Hackman), commanding the Polish Brigade attached to British First Airborne Division, who lost his temper and exploded: “But the Germans, General! What about the Germans!” The same might be said of the German political firewall: “But the electorate, General! What about the electorate!”. The firewall is a great plan in theory, all except the electorate; nobody seemed to factor in the voters.

The polls in the state election in Saxony Anhalt earlier in September in the old pre-unification East Germany had been clearly pointing to the far-right Alternative fur Deutschland (AfD) having a commanding lead, but likely to be insufficient to have a majority to govern on its own. The polls were spot on. Nevertheless, the reality in translating to the election result was still a seismic shock both in Germany and more broadly through the EU. That the AfD then went on to win in another east German state election in Mecklenburg Pommerania (again without a majority and by a much narrower margin) and made good progress even in the metropolitan election in liberal Berlin, has only added to the sense of political shock and indignation in the centre ground.

Strongly nationalist and anti-immigration, the Eurosceptic AfD’s policies reject extra defence spending, publicly support Russia, disavow Ukraine, and are overtly anti-establishment. German intelligence agencies judge the AfD to be a threat to national security. Some including the current defence minister Boris Pistorius have called for the AfD to be banned.

Therein lies the rub: even if successful legally, what is being suggested is proscribing a political party which commands an eight-point lead over its nearest rival and for which nearly 30% of the electorate intends to vote. It is not just impractical, it is plain daft. Disenfranchising 30% of voters by making their party illegal will not make the problem go away: on the contrary, the effect is likely to be explosive. In the minds of Pistorius and his ilk, proscription would pour oil on troubled waters and cool hot heads. The opposite is almost guaranteed: it will be more akin to pouring petrol on flames.

History says that every strategy employed by the establishment to contain or curtail the threat posed by the AfD has backfired. First, it was to laugh at them and to write them off as cranks: mad, bad, dangerous to know, the lunatic fringe would be likely to be a short-term phenomenon which, like so many that appear and disappear at the edges of continental politics, would quickly self-immolate with infighting and factionalism. It defied its critics. Then came the firewall invocation, initially at the local level when it first tasted electoral success, and now at state level. AfD supporters point to that success stemming from winning fairly held, fully democratic elections: to deny them the fruits of their achievement is undemocratic. In short, they claim a political stitch-up. For an anti-establishment protest party, this is electoral oxygen.

On the hard left of the spectrum, the smaller neo-Marxist-Leninist, strongly nationalist, anti-immigration, anti-NATO, Eurosceptic, pro-Russian, anti-establishment BSW party (Bündnis Sahra Wagenknecht) shares many of the same destabilising policies that make the AfD a threat to national security. The AfD and the BSW are in talks to create a coalition in Saxony that could command a majority to govern. If the AfD were banned, surely the BSW would be banned too; the same presumably also applies to the firewall.

All of this talk raises a fundamental question: once you start proscribing or suppressing parties, where do you stop? At what point are you inhibiting populist (and popular) parties simply because you don’t like them or you disagree with their arguments? Who defines what is a “danger to national security”? Is that interpretation open to political abuse?

The question goes directly to the heart of “democracy”: the voice of the people. These are immensely difficult and highly sensitive areas, particularly in today’s charged political environment in which racism and sectarianism are being weaponised for electoral gain while leaving minorities scared for their safety.

There are many factors behind the polarisation of German politics: failure to address economic and social imbalances inherited from reunification; immigration; the cost of living crisis, especially relating to energy prices in a society and economy currently almost entirely reliant on natural gas for fuel; compulsion and the price of decarbonisation; the collapse in German economic confidence as the economy stagnates; the massive blow to national prestige as Volkswagen closes factories and sheds a fifth of its workforce in the face of almost unbeatable competition from China; resentment that Germany is still expected to underwrite the debts that arise from other fiscally illiterate and incontinent EU governments; disillusionment with the political establishment; railing against America; railing against the EU; the list goes on.

But there is an essential truth that the centrist parties must face: they are failing to make the arguments, they are failing to deliver on promises and they are losing the confidence of the electorate. A series of paternalistic coalition governments have been deaf to the growing concerns of an increasing proportion of voters over the past two decades since reunification. In the last coalition which collapsed under Olaf Scholz, it was his centre left Social Democrats who were punished at the ballot box; the current centre-right Christian Democrat-led coalition (which includes the defeated SPD again) under Friedrich Merz has, in Merz’s own words, suffered a disaster: three times on the bounce in three elections in a month, including losing Berlin and most shatteringly, failing to gain sufficient votes in Mecklenburg to have any seats at all in the state legislature. This author does not have the answers, but what is patently obvious is that however tempting, proscribing or disenfranchising political parties that are winning popular mandates is certainly not it.

This is a much broader problem than just Germany: EU grassroots political momentum is shifting increasingly rightwards. 2027 sees a French national assembly and presidential election in which constitutionally President Macron cannot stand; representing the far-right National Rally, Marine Le Pen currently commands 34% of the share of intended first round votes, double that of her nearest rival; Eurosceptic National Rally shares many of the same political views as Germany’s AfD: anti-immigration, sympathetic to Russia; not exactly anti-NATO but very much qualified in its support etc. Meanwhile in Italy, Georgia Meloni’s already right-wing Brothers of Italy party is being harried by the ultra-right-wing Roberto Vannacci and his Futuro Nazionale party ahead of the election in December 2027.

In among all the immense geopolitical tensions, especially the titanic competition between China and the US (despite General Secretary Xi saying that the US and China should cooperate instead of being rivals), Europe and the other Middle Powers including the UK and Canada are seeking solace and security in a world where norms have been upended.

The EU compounds its own problems through being a far from complete political project; when it comes to policy and decision making, of the four governance pillars (Commission, Council of Ministers, Court, and the Parliament), the Parliament comes a distant fourth; and through an ill-constructed electoral and representation system, the electorate has become almost irrelevant. The electorate is not literally disenfranchised in that it cannot exercise its right to vote; but it might as well be when casting a vote is seen to make no discernible difference to the outcome. It is this perceived democratic deficit at the core of European politics which is making itself felt through polarisation and populism.

The natural reaction at the centre (the “establishment”) is still to reject populism as a threat and an aberration. Recalling former EU Commission President Jean-Claude Juncker: “populism must be stamped out”, a view which finds much misplaced sympathy in Brussels. Actually, the antidote is about vision, political leadership, and the ability to make and win arguments.

Investment perspective

The investment relevance is simple: changing political opinions are reflected in electoral results. Changes of administration mean a change in direction which, whether it be economic, security or social policy, affects budgets and fiscal policy. Uncertainty creates volatility; investors like to model future outcomes and differentials from previous assumptions; they discount back to a theoretical value today using a discount rate which itself reflects the changes in and perceptions of risk when appraising the value of assets. All tipped in the melting pot, it is as they say, what “makes a market”.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.