The votes in the German federal elections were counted, but the result was far from decisive. It may take weeks, if not months, to figure out who will succeed Angela Merkel as the next Chancellor. The conservative Christian Democratic Union (CDU / CSU) and the center-left Social Democratic Party (SPD) are head-to-head, with neither having enough votes to form a government on its own. Given the wide dispersion of seats among six factions, the two most likely options for the next government will be three-way coalitions of one of the two main parties with both the Green Party and the Liberal Democratic Party (FDP) . A prosecution of the “grand coalition” of the CDU / CSU and the SPD has already been ruled out by both parties. Given the wide range of political agendas in either constellation, we anticipate that any potential impact on the market will be limited, although stocks, high yield corporate bonds and the euro could all benefit from fiscal stimulus and higher interest rates.

Election results and possible coalition options (seats)

Source: Bundeswahlleiter

Overall, the Social Democrats and Greens are more likely to increase public spending – financed by higher taxes and more debt – while the Union and the FDP will almost certainly insist on (re) enforcing the “debt brake”¹. Therefore, every possible coalition will have at least one party that insists on spending more and one that tries to limit additional borrowing. That said, any new government will still have to deal with the current COVID crisis, which will make any fiscal consolidation difficult, especially with the European Central Bank also intending to reduce its support at some point. Soaring consumer prices and rising interest rates in other parts of the world are sure to put further upward pressure on German borrowing costs.

Still, higher sovereign yields aren’t necessarily a bad thing. On the contrary, given the current positive correlation between long-term government rates on the one hand, and stock prices and exchange rates on the other hand, the stock markets and the euro might even fall apart. appreciate. Narrower credit spreads can also benefit corporate bonds, especially at the lower end of the rating spectrum. To estimate the impact of the rise in Bund yields on these different asset classes, we carried out a series of so-called transitive stress tests using Axioma Risk â„¢, Qontigo’s multi-asset class analysis platform. We applied a moderate 30 basis point bullish shock to the 10-year German Bund yield, which from its current level would make it almost positive. Covariances and beta with other pricing factors, such as credit spreads, stock prices, and exchange rates, were estimated using weekly returns over the six months following each of the last four federal elections. Figures for 2021 were calibrated from the most recent 6-month period ending September 24.

The graph below shows the simulated performance of a portfolio of sovereign and corporate bonds denominated in euros, broken down by general rating. Modeled returns include the effects of higher risk-free rates, as well as the estimated contributions of the concomitant changes in credit spreads and accrued interest over six months (assuming current yields to maturity). The calculation of price movements assumes a modified average duration of 5 years.

Simulated total returns for a 30 basis point rise in 10-year Bund yields over six months

Source: Risk of axiom

Despite very different economic environments during the different calibration periods, the simulated returns appear to be quite similar. The performance of the German Bund is mainly driven by the shock of the benchmark 10-year rate. With an assumed duration of 5 years and current yields close to zero, the rate shock of 30 basis points roughly translates into an expected total return of -1.5%. The highest rated corporate bond (AAA) category shows similar or slightly lower performance. In contrast, losses for the rest of the investment grade universe (AA to BBB) are slightly lower, as they appear to benefit from tighter credit spreads, while the interest income effect is still negligible. It’s also worth noting how consistent their returns are, not only across all scenarios but across ratings as well, almost as if relative creditworthiness isn’t a major concern for quality investors.

The picture is very different, however, once we get down to the speculative level. Particularly as one descends further down the spectrum of single-B and triple-C ratings, the expected returns become increasingly positive. Certainly, this is largely due to the substantial performance bonuses of these stocks, which account for almost all of the expected income. Yet implicit changes in credit spreads also offset most of the adverse effects of rising risk-free rates.

The expected performance of Italian government bonds needs to be examined in more detail. Peripheral sovereign issuers also often benefit from tighter credit risk premiums. Particularly in the 2009, 2013 and 2017 scenarios, BTPs posted much lower losses than corporate securities with comparable ratings. However, these periods have also represented periods of heightened volatility for Italian debt, namely the recovery from the euro area debt crisis of 2011/12 and the period leading up to the Italian general elections in 2018. More recently, the Euro-sovereign debt in general has been supported by the European Central Bank’s emergency purchasing program in the event of a pandemic. For now, the support mechanism remains in place, but the relative performance of Italian debt versus German debt could also depend on the dominant forces in Berlin. The CDU / CSU and the FDP have rejected a European fiscal union, while the Greens and Social Democrats may be more willing to extend the current joint borrowing program beyond the corona crisis. An agenda set by the latter two could therefore result in greater convergence of borrowing rates between governments in the euro zone and, subsequently, in a tightening of the BTP-Bund spread.

In stock market terms, the anticipation of increased budget spending would give the German economy a much needed boost, especially in the ongoing recovery from the COVID crisis. The stress test results for the DAX^® and EURO STOXX 50^® the indices in the graph below seem to confirm this notion, with gains expected in all scenarios except 2017. It is probably no coincidence that the latter implies a decline in stock prices, as the underlying environment was characterized by increased uncertainty, caused by the protracted coalition negotiations at the time. It serves as a warning that a repeat of the 2017 coalition dilemma could still lead to weaker stock markets after all.

Equity and currency returns simulated for a 30 basis point rise in 10-year Bund yields over six months

Source: Risk of axiom

Higher bond yields could also cause the euro to appreciate against the US dollar, as higher expected yields tend to make a currency more attractive to foreign investors. The current correlation regime would certainly favor a stronger exchange rate, although the evidence for historical scenarios is less conclusive. That said, EUR / USD has climbed higher in the top six, after each of the last three German elections (2009, 2013 and 2017).

[1] The so-called “debt brake” – temporarily suspended in response to the COVID crisis – was introduced into the German constitution in 2009 to limit the federal structural deficit to a maximum of 0.35% of GDP.