What's takeaway 1 on Across the Pond?

Friedrich Merz's leadership may signal increased German spending.

What's takeaway 2 on Across the Pond?

A focus on independence from the US could bolster Euro strength.

What are the market implications for Across the Pond?

Traders should closely monitor movements in EUR/USD, particularly any developments surrounding fiscal announcements from Germany. A confirmed upward shift past 1.08 could signal a stronger bullish trend, emphasizing the need to reassess positions accordingly.

What are the risks to this view on Across the Pond?

Potential risks to this outlook include a stalled implementation of Merz's spending plans or significant geopolitical tensions that could diminish investor sentiment towards the Euro. Additionally, any shifts in ECB policy or unexpected economic data releases could lead to a stronger Euro against the dollar than currently anticipated.

Across the Pond: Is Germany’s chancellor-in-waiting Merz the comeback kid?

What the desk is arguing

The desk posits that the renewed focus on domestic spending and independence from the US under Merz could act as a catalyst for Euro strength. This reflects a significant shift in sentiment that might invigorate economic momentum and redefine investor confidence in Germany's fiscal policies.

Support for this view is bolstered by the DAX index's recent performance, which indicates a market responding positively to potential policy changes. While Merz's commitment to increased defense and infrastructure spending could lead to enhanced growth prospects, implications for monetary policy from the ECB will be crucial to monitor as these developments unfold.

Where it sits in our coverage

As of now, our consensus target for the EUR/USD stands at 1.075, with a range indicated by JPMorgan forecasting 1.10 and Bank of America at 1.04 for the March 2026 tenor.

This perspective aligns closely with jpmorgan, which sees upward momentum for the Euro, while bofa holds a more cautious view at the lower end of our spread. This suggests that the desk's outlook leans towards the optimistic end of the current projections.

How other firms see it

Firms like jpmorgan and deutschebank exhibit alignment with the bullish sentiment on the Euro, primarily due to anticipated fiscal policies. Conversely, bofa and citi present a more skeptical outlook, potentially foreseeing challenges to the Euro's strength amid geopolitical uncertainties.

With respect to currency pairs, the EUR/USD is expected to reflect broader economic conditions in Europe, as well as the Federal Reserve's policy intentions, specifically in relation to interest rate differentials. Observers should also keep watch on the influence of the European Central Bank's decisions as the situation with Merz evolves.

Welcome to another episode of Across the Pond, where we discuss the big stories and top investment ideas from the Eurozone and Switzerland. 2024 was a record year for democracies, with elections taking place in countries that are home to more than half of the world's population. And perhaps the highlight was the massively consequential US election. By comparison, Germany's recent election was expected to be something of an afterthought.

But could the outcome mark a turning point for Europe's largest economy and the region as a whole? Germany's Chancellor-in-Waiting, Friedrich Merz, has promised independence from the US, having become convinced that the Trump administration is largely indifferent to the fate of Europe. And he's trying to win approval for almost a trillion dollars of additional spending on defence and infrastructure.

That would be a big shift for a nation that is notoriously frugal. That comes at a time when Europe is making a bid to narrow the gap with the US and China on AI. So will this be seen as a turning point for Europe?

Is Europe the comeback kid or headed for the retirement home? These are some big questions to chew on. Today, I'm joined by Paul Donovan, the CIO's chief economist and a man very much accustomed to dealing with such weighty issues.

Thanks for coming along, Paul. Thanks for having me on. Great.

So basically, the German elections, these can be something of a mystery for people outside the country, given the multitude of parties. Perhaps you can just explain what the outcome was, what it means, and what we might expect from Germany's new incoming government, because of course, the coalition talks at the time we're discussing this haven't yet been finalised. Well, the basic conclusion is that there is going to be a change of government and what is known as a grand coalition in all probability.

That is to say that the outgoing Social Democrats will now become a junior partner to the larger Christian Democrats, which is the more right-wing focused party. The change in government itself was not a surprise. This is part of actually a global trend where incumbents have been kicked out pretty much around the world, whether left-wing or right-wing.

In the UK, it was a right-wing incumbent government replaced by a left-wing, and in Germany, a left-wing government being placed by a grand coalition with a right-wing focus. The quirk in the German election is that the electoral rules in Germany say if you don't get 5% of the vote, you don't get any seats at all. And so that was quite an issue this time, because there were several smaller parties that were scrambling around the 5%.

A couple of them, including a pro-business party, didn't make that threshold. So it leaves us now with essentially five parties in the parliament, as I said, the grand coalition. That itself is not especially surprising, although it is noticeable that the incoming government does not have enough votes to change the constitution.

They'd need to get a third party on board to do that. So I was getting very excited prior to our broadcast, because just as we're recording, we had some very interesting, what I thought were very interesting, comments from Friedrich Mertz, who's the chancellor-in-waiting, to the effect that he was planning a very, very large package on defence and infrastructure. He's made some very interesting comments about wanting independence from the United States, and as I said, expressed this view that the US doesn't seem to care that much at the moment for the fate of Europe.

You seemed, as we were coming into the studio, somewhat less excited about this than I was, and perhaps you can just talk me through what's happened and what you think it means. So the German government is going to be increasing spending on defence, as you say, but it was always going to do that. I think that over the course of the last few months, there has been a clear shift in Europe and a recognition that the United States may not be quite so dependable as an ally in the future.

Friedrich Mertz himself has been expressing that, and that therefore defence spending will shift. Now, it will shift in two ways. It will shift in as much as there will be an increase.

That has been on the cards for a long time, really, ever since Russia invaded Ukraine. But also, I think now, and this is the new aspect, that that defence spending will be focused on European companies, not on US companies. So an overwhelming majority of continental European defence spending has been directed towards US manufacturers over many, many years.

There is now, I think, a very, very conscious effort not to allow that to happen. So the defence spending that is being talked about will actually be more of a European economic stimulus. That's not why they're doing it, but it will be more of a European economic stimulus, and that's one of the shifts that's coming through.

Again, I think these are trends that certainly were likely, almost regardless of the election outcome. What we have had here is perhaps a more robust statement from Mertz about the intentions of the incoming German government. It's not been sort of disguised in flowery diplomatic language.

It's been quite bluntly presented. And if you put this in the German economic context, obviously, like in recent, over the past year, Germany's flagship auto industry has just faced an awful lot of headwinds. I mean, in that context where many German consumers or sort of well-paid members of this industry might have been feeling a little nervous, presumably the idea of a sort of big shift towards European contractors might be something of a relief here.

I mean, maybe you can give me a sense of what you think this might mean for business confidence in Germany. Well, the consumer in Germany has actually not been very worried. Although Germany has had negative GDP growth, the consumer has actually been positive over the last year.

And German consumers have, if not been exuberant, have certainly been spending. The auto sector gets a lot of headlines because it's a large weighting in the equity market. It's not so important in the German economy.

It's less important than it used to be. And it's even less important when it comes to the levels of employment. So I don't think it necessarily changes consumer confidence around that.

But I think in a broader sense, the idea that there is going to be what is in effect a fiscal stimulus to Europe, it should be said, not specifically to Germany, though Germany will be a beneficiary, that's something which is perhaps reassuring about there being a bit more of an underpinning, a bit more of a foundation to economic growth. I mean, it's noticeable that the economic exceptionalism of the United States over the last few years has largely been about the fact that the U.S. is prepared to run very, very large fiscal deficits and Europe wasn't. And now we're not going to see U.S. style fiscal profligacy coming through in Europe.

But a higher deficit coming through in Europe is something which will offer an additional foundation of support to medium term trends of European growth. And for outsiders as well, I mean, I've been reading a lot about Germany's debt break and not entirely sure that I understand how it functions. And perhaps you can give a sense of what have been the restrictions on German borrowing and can this be overcome?

So the German debt break is an attempt to limit the size of the deficit with certain exceptions. And the important point here is there's a limit set in the constitution. And that means that the constitutional court has actually on occasion had an opportunity to rule on fiscal programs and say, no, this is unconstitutional versus constitutional.

And the German constitutional court is quite a conservative institution in the sense that it tends not to like a very aggressive or expansionary interpretations of the constitution. Now what is happening here is a proposal that defense spending would be exempted from this break, for example, and that that would allow more fiscal stimulus in certain areas. Now the principle of certain forms of government spending are still constrained.

That's still there. But you would basically broaden the exemption categories. I suppose that seems to be the way that the government is going.

Now as I mentioned earlier, the incoming government does not have a large enough majority to change the constitution, which is required to change the debt break. But the two parties that are likely to form the incoming government do have a large enough majority in the current parliament because the current parliament hasn't reformed. So there is an opportunity now perhaps to change the debt break using the old number of seats in the parliament.

And then it doesn't matter that the new government wouldn't have that. So that's what is being discussed as a way forwards. Yes, I don't want to date this podcast too much, but at the time we're recording, the DAX index is sort of rather unusually one of the best performing major indices of the year is like around 15 percent higher.

I mean, that seems a little unusual at a time when the U.S. President Donald Trump has been making some very ominous noises about imposing extra tariffs, including on the German auto sector. What's going on here and do we think this can continue?

Well, I think what we've got here is a number of factors. So the first is the idea that there will be fiscal stimulus, which we domestically focused on. I focused on European companies of which the DAX will be a beneficiary.

The second thing is that the European economy is not doing that badly. And in fact, we would expect stronger growth this year on domestic demand in Europe. Essentially, European consumers have been quite inclined to save money in recent years.

And they, we think, are now reaching the limit of that saving. So additional income and real incomes are growing in Europe is more likely to be spent than saved. And that, of course, is also a domestic improvement.

The focus on technology has perhaps shifted a little bit. Well, Europe does not produce technology, it uses technology. And so as people are saying, well, actually, how does the use of technology and technological change actually aid the European economy?

That provides some support. And finally, yes, there is obviously a lot of noise about taxing German, taxing US consumers through trade taxes. But there are a couple of points that are worth thinking about here.

US President Trump is quite often talking about universal taxes, the US versus the rest of the world. Whereas from the European perspective, what you would be experiencing is taxes in one market that you sell to. And the most important market for Europe is Europe, not the United States.

So the balance of these tariffs, it's a negative, but it's not an overwhelming negative. One of the other things for the auto sector to consider is that the tariffs that President Trump is imposing on imports from Mexico potentially do a lot of damage to US auto companies and will raise US auto prices because they use components from Mexico in their cars. And these are now going to be very aggressively taxed as things stand.

I mean, this is a very fluid situation. But that means that actually, even if tariffs are imposed on European cars, they are not necessarily at such a competitive disadvantage because American-made cars are going to be subject to the same sort of sales taxes via the components that European cars are with a final tariff coming through. So there's lots and lots of complicated issues here.

But essentially, there is a certain amount of good news around the European economy, around the German economy that can be applied to the equity market. There are risks. There's certainly a lot more uncertainty and noise, but it's not all bad news.

And then, you know, around the turn of the year, there was a lot more concern about France following Macron's decision to call an early election, which didn't go terribly well for his centrist allies. What's the latest on France? As far as the French situation is concerned, we have a minority government, which is sort of not doing very much.

It's sitting there. When you have this sort of situation, the French presidency tends to take the lead in foreign affairs, and the government tends to take the lead in domestic affairs. So you've got quite a lot of inertia.

Not much is really happening on the domestic side. But of course, Macron has been taking quite a high-profile role in international affairs. And there are some interesting longer-term consequences, perhaps, of US politics and the implications that that has for other countries.

Now, this is very visible outside of Europe, in Canada, where the Liberal Party has had a resurgence in the polls because of the antagonism with the United States, and that has led to support for Prime Minister Trudeau's Liberal Party. If we look at Europe, the intervention by Musk, Trump's influential donor, in German politics, the intervention by Vance in German politics, actually, it seems, led to a decline in support for the far-right Alternative für Deutschland party, because Germans resented the interference, and its association with Alternative für Deutschland actually damaged, to some extent, AFD's support. So there's an interesting question now about Le Pen in France, as the far-right politician, and whether her party is going to be tainted by association in the eyes of French voters with the position of Trump and so on, which is generally not popular in Europe.

So the dynamic in French politics, as in many other countries, is shifting, because association with what is happening in the United States is not necessarily going to be a vote winner. So some of the dynamics on politics this year, the role that Macron pays as a defender of Ukraine, that kind of thing, could be very, very interesting in how this reshapes the political landscape in France, from one which was looking very chaotic to one where perhaps there is more support for centrism in the future. That is interesting.

And I noticed as well that Macron has been making some announcements on AI. I guess it's just one of those things where we're all talking about it. I've even started doing a course on it myself.

But I wasn't sure, is this just sort of me too-ism, or does this have potential in France and maybe more broadly in Europe? So I think that there is a certain amount of gesture politics that is going on. The politician's paradox, we must do something, this is something, we must do this.

And I think that there is that element that comes in. And how much a government pronouncement or a government czar of AI is actually going to make a difference in the long run in any country, I'm quite sceptical. I think the interesting thing for Europe on AI is that the application of artificial intelligence, particularly in an aging society as most of Europe is, has some really quite interesting implications for the European economy.

And ultimately, it is how technology is used that makes the real difference to long-term trend rates of growth and long-term productivity. And applying artificial intelligence to create efficiency gains within the aging society, within the established industries, and frankly, the established public sector of Europe, that could be quite interesting over the medium term. So that's where I start to get quite excited.

That's actually rather promising. What about, I mean, so more broadly within Europe, then, you think that there are sort of good applications within, for using AI? I mean, are there particular industries that you think could benefit most?

So I mean, the industries are likely to be the same as is the case elsewhere. So things like medicine, for example, where AI is offering some very clear advantages to improving diagnosis, for example. Now, in a society that is aging, improving the efficiency of medical diagnosis is no small thing.

It carries with it potentially disproportionate importance. And there's other areas where one could imagine, for example, government administration could be rendered more efficient, potentially, with appropriate application of AI, done so in a judicious way. And again, the government share of GDP in Europe is relatively high compared to others in the OECD.

So there are areas where efficiency gains would have a disproportionate advantage in Europe compared to other advanced industrialized economies. Oh, that's really interesting. So going back maybe just a little to the short-term outlook, I mean, you sounded a little more optimistic than I noticed some commentators have been on the outlook for the Eurozone economy in 2025.

I mean, perhaps you can just give us a clearer sense of what you think the growth rate might be this year. Does the latest German spending package or anything else and potentially a cessation of hostilities in Ukraine pose, I guess, what we would call upside risks, although I never particularly like that term? So the spending package was something that we were factoring in some assumptions about spending.

The details need to be worked out. But it would be a positive. The potential for secession of hostilities in Ukraine, if it's a ceasefire, I'm actually quite cautious on the growth implications of that because, frankly, defense spending was going to happen anyway.

A ceasefire is not going to change that. I don't think that Europe is going to be massively increasing its purchases of Russian gas, ceasefire or no. There's no trust there.

So the idea of energy independence is not going to disappear. What really has been driving the idea that Europe sees a little bit more growth this year than it did last year is the fact that the European consumer is likely to spend a bit more money, that the stock of savings, the amount that's tucked away under the mattress or put away in your bank is now actually relatively high and there's no real desire to increase that stock any further. That then pushes consumers to spend a little bit more.

And much like consumers in the States or consumers in the UK, for that matter, the spending pattern has been focused on spending on having fun rather than spending on goods. And that's important to bear in mind. I mean, you look at the Spanish economy, Spain's outperformed the United States for several years now because Spain is somewhere you go when you want to have fun.

The Greek economy has been doing very, very well. The goods manufacturing economies like Germany have underperformed. If Germany sells goods, it doesn't sell fun.

And so there it's underperformed. But where you've got economies that have been focused on the trends in consumer spending, they've tended to outperform very much. So, yeah, like taking maybe a sort of getting closer to wrapping up here, I haven't looked at our latest forecast, but as far as I remember, like our forecast for eurozone growth is still roughly at about half the rate that we see the US economy growing.

I mean, is that, do we think that's the trend rate of growth, that Europe just grows at about half the rate that the US does? And if so, that kind of raises concerns about the long-term outlook for Europe? Well, this year, I think actually Europe will probably grow a bit faster than half the US rate.

But what we've got to remember is that Germany has a falling population. Italy has a falling population. That's two of the big three European countries.

France's population is basically stagnant in terms of its growth rate. So what you have here are aging societies with populations that are not growing. Now the United States, unless President Trump is particularly successful in deterring migration, has a rising population.

So economics 101 tells you rising population, rising growth, falling population, negative bias to growth. It doesn't actually mean falling growth necessarily, but negative bias. So on a per capita basis, growth in Europe will be a lot closer to that of the United States.

But there's another characteristic with aging populations, which we're going to have to start paying more attention to, and particularly I think in Europe and the UK, and we've been starting to do in Germany. And that is that as populations age, people contribute to the economy without contributing to GDP. Because what you find is that older people will volunteer.

You don't sort of go brain dead at 70 when you retire, at least I certainly hope not, dim prospect for me if that is the case. You carry on, and you find something else to do, and very often that will be volunteering, which has an economic value, but not one that's captured by GDP. Because volunteering does not contribute to GDP.

Being a volunteer does not contribute to employment. So what we're finding is things like parts of the cultural sector, the entertainment sector, old age care, childcare, these are now being done by volunteers, or in the case of some grandparents, sort of volunteers, and that is being taken out of the GDP. But it doesn't mean that economic well-being is suffering.

Economic well-being can actually be flourishing in that environment. So it's one of those things which economists get really excited about, and it's not yet hit the real world, that actually GDP is not necessarily capturing standard of living quite so well, and the gap between GDP and standard of living is probably going to grow in Europe, where standard of living will be doing better than the GDP numbers suggest. Thanks again for your time, Paul.

I feel a bit more sort of optimistic about Europe, but slightly less excited than I was when we came in about the German news. Thanks to our listeners as well. We can't delve into specific securities on these podcasts.

You can explore some of these with your UBS representative. And we also very much recommend our equity compass, which goes into full detail about where we see most value. We'll be back soon with another installment of Across the Pond.

In the meantime, have a great week. Thank you for tuning in. Be sure to visit ubs.com slash studios to view the entire UBS studios suite of podcast channels along with our video offerings, such as UBS Trending.

You can also follow us on Instagram for content highlights at UBS Trending. UBS Studios is part of the UBS Chief Investment Office within UBS Global Wealth Management. Visit ubs.com slash CIO to view the latest research.

UBS Chief Investment Office's investment views are prepared and published by the Global Wealth Management business of UBS AG or its affiliate UBS. This material has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only. As a firm providing wealth management services to clients globally, UBS AG and its subsidiaries offer both investment advisory services and brokerage services.

Investment advisory services and brokerage services are separate and distinct, differ in material ways, and are governed by different laws and separate arrangements. In the USA, UBS Financial Services Inc. is a subsidiary of UBS AG and a member of FINRA-SIPC. For information, please visit our website at ubs.com forward slash working with us.

For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at ubs.com forward slash CIO dash disclaimer.

Institutional FX coverage in your inbox