The center-right returns to power in Germany but faces many challenges

The conservative alliance made up by the Christian Democratic Union (CDU) and its sister party the Christian Social Union (CSU) is set to lead Germany again following the federal election on Sunday, bringing an end to a period of political instability that has dogged Berlin for months.

The center-right CDU-CSU won 28.6% of votes, with the far-right Alternative for Germany (AfD) coming in second place with 20.8%, while the center-left Social Democratic Party (SPD) came in third with 16.4% of the vote, according to preliminary results from the Federal Returning Officer.

The results, which will be confirmed later on Monday, mean the CDU-CSU’s candidate Friedrich Merz will likely be installed as Germany’s next chancellor, taking over from the SPD’s Olaf Scholz after his three-party coalition collapsed late last year.

“We have won it because the CDU and CSU worked well together and we prepared very, very well for this election and also for taking over governing responsibility,” Merz said on Sunday as exit polls emerged, signaling the alliance’s victory.

The win for the Christian alliance brings an end to a period of uncertainty in Europe’s largest economy, although there could now be weeks of political horse-trading as a coalition government is formed.

The most likely outcome is for the CDU-CSU to form a two-party coalition with the SPD, a tried and tested coalition formula in Germany, although a three-party coalition made up of the CDU-CSU, SPD and Greens is also a possibility.

Merz had already ruled out forming any governing alliance with the anti-immigration, populist AfD party, which saw its best election result ever on Sunday.

Merz “clearly has a mandate to form a new government,” David McAllister, CDU politician and member of the European Parliament, told CNBC Monday.

“He will be a very good chancellor because I know him for many years, we can absolutely trust this man and hopefully he can bring confidence back, he can restore confidence in Germany, that is his main task and I wish him all the best for that.”

European markets have had a somewhat muted reaction to the election result although Germany’s DAX stock market index opened around 0.4% higher on Monday.

But despite this respite, the new German government has a lot to contend with.

Political division in Berlin has been seen as an undesirable distraction by investors who warn that Germany must overcome a series of challenges. These include an economic malaise that has gripped the country in recent years, with its car-and-export-orientated economy looking vulnerable, as well as a thorny debate over immigration and integration that has seen the likes of the AfD rise in prominence and popularity.

Germany’s wider role in European geopolitics is also a matter for debate, particularly given the ongoing war in Ukraine, and as U.S. President Donald Trump and his trade tariffs threat pose another potential headwind.

Economists are considering what a CDU-CSU-led government means for Germany’s economy and fiscal reform after lengthy debate and division over Germany’s “debt brake,” a fiscal policy that’s enshrined in Germany’s constitution, limiting how much debt the government can take on.

Strategists at Deutsche Bank noted that while the election result “may reduce the risks of particularly fractious coalition talks, it still confirms an ongoing anti-establishment trend that has been visible both in Germany and Europe as a whole.”

“The result marks the lowest ever vote share for the two major parties, even as the turnout (82.5%) was the highest since at least 1990. And it leaves the centrist parties short of a 2/3rds constitutional majority, with the CDU/CSU, SPD and Greens jointly at just under 66% of seats. That means any debt brake reform, including for defence spending, would require support from one of the fringe parties. This may not be impossible, but it would require significant political compromises,” they wrote in a note.

The fiscal policy has proved to be a persistent political bugbear for Berlin, with arguments between parties over the extent to which the debt brake ensures responsible spending, or limits growth and investment.

Both arguments could be moot points for an economy that has been flirting with recession for months.

“The less bad news first: Germany will get a new government that can put an end to a long period of debilitating political uncertainty once it has agreed on its agenda,” Holger Schmieding, chief economist at Berenberg Bank, said in a note Monday.

“We expect a two-party coalition between the CDU/CSU and the centre-left SPD to enact some pro-growth supply-side reforms, ease the regulatory and tax burden on businesses somewhat, and pursue a more rational immigration and a less inefficient and costly energy policy,” Schmieding noted. He questioned, however, the extent to which populist parties such as the AfD and The Left (Die Linke) could combine and block changes to the German constitution, such as loosening the debt brake rule.

Other economists noted that The Left (Die Linke) has signaled that it’s actually in favor of reforming the debt brake rule and will not stand in the way of such a move.

“Although the AfD and The Left together appear to have the number of seats required to form a blocking minority for constitutional amendments and reforms, which require a two​-​thirds majority in parliament, we note that The Left is in favour of reforming the debt​-​brake rule,” economists in Barclays Cross-Asset Reserach team said in a note Monday.

“Therefore, although still at risk, we think that it is more likely than not that a new coalition government will reform it and modestly ease fiscal policy,” they noted in emailed comments.