By the time the new German Chancellor, Friedrich Merz, takes office in late April or May, he will already have two significant political achievements under his belt. First, the abandonment of German ‘austerity’ in a seismic shift towards more defence and infrastructure investment, agreed in a matter of weeks in the dying days of the outgoing Bundestag. And second, negotiation of a “grand coalition” agreement with his party’s rivals, the outgoing Social Democratic Party (SPD), of whom Merz was so critical during the election campaign.
However, taking office will be no cause for self-congratulation. Huge though those early accomplishments are, they are just the beginning of the challenges the next Chancellor will face if his government is to restore Germany’s economic prospects and fend off the growing threat from the far-right.
After enduring two years of economic contraction, and with growth this year predicted to be an anaemic 0.3%1, transforming Germany’s growth prospects will be the most serious challenge facing the new CDU-led government.
The massive package of fiscal expansion will undoubtedly help, with the impact of the infrastructure fund projected to lift GDP growth in 2026 from 1.1% to 2% or more.2 However, the profile, detail and efficiency of the additional defence and infrastructure spending will be critical.
The new government will give its first detailed indications when it negotiates, in its first months, the budget for the remainder of 2025 as well as for 2026. Having ‘conceded’ such a major U-turn on government spending to the SPD – at some cost to his own credibility within the CDU and with the wider electorate - Chancellor Merz will need to demonstrate early progress on some of the CDU’s pre-election commitments. Tackling high taxes, high labour and energy costs through a package of supply side reforms will be high on the list.
These reforms are expected to include tax reform, having pledged tax cuts both for lower and middle earners as well as German businesses, and modernisation of Germany’s labour laws plus efforts to cut business red tape.
In addition to the CDU performing an historical volte-face on the debt-brake, Friedrich Merz is also having to rethink his approach to relations with the United States. After pledging in the CDU manifesto to “strengthen the transatlantic partnership as the foundation of the Western world”3, many were surprised to hear Merz – a committed Atlanticist – declare after his party’s election victory his ambition to step-by-step “achieve independence from the US”.4
Despite committing to a massive increase in defence spending, Germany is regarded with some suspicion in the Trump White House due both to historic underinvestment in defence and to having recorded a record trade surplus with the United States in 20245. Germany’s car industry – and, to a lesser extent, pharmaceuticals – stand out as particularly exposed.
With US tariffs on cars already announced, and further sectoral tariffs on pharmaceuticals expected, the new German government will need to actively engage with the European Commission as it formulates the EU’s response – both in its approach to retaliatory measures and in seeking a negotiated overall settlement to the trade dispute.
Alongside economic transformation, rebuilding and rearming Germany’s hollowed-out armed forces, will be one of the new government’s defining tasks. Embarrassing episodes, such as offering Ukraine only 5,000 helmets on the eve of Russia’s invasion, are now in the past6. But the task of fulfilling Olaf Scholz’s 2022 announcement of an historic turning point – zeitenwende – in German defence policy remains.
The recent fiscal reforms theoretically provide the new government with an unlimited defence budget. Consequently, attention is now turning to the speed at which the new government can efficiently deploy the additional resources while providing the long-term order book the defence industry requires to invest in increasing its manufacturing capacity.
While the fiscal reforms provide for defence spending to encompass wider areas such as intelligence services and civil protection / resilience measures, a key area of debate will be the extent to which the extra funds are used to backfill existing capabilities, invest in new areas such as cyber, connectivity and autonomous platforms, or contribute to identified EU-level capability gaps such as missile defence.
Following on the heels of Chancellor Scholz ‘s low-key stance on EU relations, Chancellor Merz is expected to adopt a much more proactive and engaged approach. While political instability persists in France, total renewal of the traditional Franco-German motor at the heart of EU policymaking may prove difficult. Nonetheless, Merz has already made his intentions clear, making a surprise visit to Paris to meet the French President in the middle of domestic coalition talks.
Indeed, the CDU election manifesto pledged to revitalise relations with both France and Poland. An early opportunity to demonstrate German leadership will come at the NATO Summit in the Netherlands in June, at which European NATO allies will need to formulate a collective response to the US demands for an increase in the official defence spending target. However, tensions could arise over CDU plans to make permanent Germany’s temporary border checks to clamp down on irregular migration and asylum claims.
Through the major fiscal reforms and coalition talks with the SPD, Merz’s CDU party is already under attack from the far-right AfD for aligning with the ‘centrists’ that he previously had criticised.
As leaders of the opposition in the next Parliament, the AfD will gain a new prominence in German politics. The CDU will need continually to be alive to the threat that the compromises forced by the necessity of coalition present to their prospects of re-election and to the further rise of the AfD.
A particular challenge will be seeking to bridge the domestic divide between the Eastern states – from which the AfD derives the bulk of its support due to issues such as immigration and a greater sense of popular disenfranchisement – and Western states.
While additional budget flexibility to enable investment will help, ensuring that any economic success is spread across the country will be important in facing down the AfD threat.
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1 World Economic Outlook Update, January 2025: Global Growth: Divergent and Uncertain
3 wahlprogramm-cdu-csu-kurzfassung-englisch.pdf
4 Trump, Merz and the future of the US-German friendship – DW – 02/27/2025
5 Germany's trade surplus with US reaches new record | Reuters
6 Ukraine Support Tracker | Kiel Institute
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Data as at 01.04.2025, unless otherwise stated. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Views and opinions are based on current market conditions and are subject to change.
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