Merlin Weekly Macro: German elections have seismic ramifications

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This has been a macro-observer’s week from heaven, such is the plethora of material it has thrown up. Like a child in a sweet shop, there is just so much in the window that grabs the attention demanding to be devoured.

Germany: political earthquake

Narrowly short of winning an outright majority (almost impossible under the German electoral system) the hard-right AfD’s stunning success last weekend in the Saxony Anhalt state election was everything it could have dreamed of. The centre ground is reeling in paroxysms as the Voldemort of German politics not only makes waves but seems unstoppable. At the two extremes of the political spectrum (where they almost meet around the back of the circle), the hard-right anti-immigration, pro-Russian, anti-establishment AfD is seeking to stitch a deal together with the small hard-left, anti-immigration, anti-NATO, anti-establishment BSW (Bundnis Sahra Wagenknecht) sufficient to form a state coalition in Saxony. If it succeeds, for the first time since 1945 a unitary authority will be under a populist nationalist socialist government. Join the dots.

Next up, September 20^th and another former DDR state election, this time in north-east Germany in Mecklenburg Pomerania on the Baltic coast; while by a smaller five-point margin over the Social Democrat SPD, the AfD is leading the polls there too with 36%. Trailing far behind with 8% is Chancellor Merz’s centre-right CDU.

Piling on the political pressure is the travails of Volkswagen as it announces the loss of another 50,000 jobs bringing total redundancies to 100,000 (it began the year with 660,000 employees). A totem of German industrial post-War might, this is a national disaster as Germany’s automotive industry succumbs to intense targeted strategic competition from China.

With cabinet support faltering, the hapless Merz is already on notice that his federal leadership is terminal if the Mecklenburg election goes badly. The ramifications for Germany and the wider EU are significant. We will return to this story later in the month.

Healey reveals his true colours

Then there is the national scandal of the UK Ministry of Defence as, in sequential years, it runs out of operating budget again. This time there are seven months of the fiscal year still to run. All non-operational regular force live firing training has been cancelled in the Army and reservist training programmes are being curtailed. Only one person is ultimately responsible: immediate former Defence Secretary and now Chancellor, John Healey. Andy Burnham said this week that he will never jeopardise welfare for defence spending, very obviously with Healey’s collusion. It is increasingly obvious that Healey’s resignation in June over the inadequacies of the Defence Spending Plan was not a principled position, merely a cynical and premeditated act of political regicide both to finish off Starmer and to advance his own prospects.

“We’re doomed! All doomed!”

As for a former Anthropic researcher going public that his and competitors’ AI product developments could wipe out all human life within ten years, the genie is out of the bottle. Impossible to return it, surely the challenge is to tame it. Veteran 85-year-old US Senator Bernie Sanders acknowledges AI’s potential benefits for healthcare and other applications. However, worried about the potentially existential damage it can do if managed badly, he aims to tame it through legislation: “When even the people who have developed it say they don’t know where it’s going, you’d be a moron at least not to slow it down. Slow it down!” Good luck with that.

The Donald strikes back

But in the end, almost inevitably, it is The Donald who claims our major attention. His appearance at the Dallas Republican Convention ahead of the November mid-term elections was vintage Trump. 100 minutes of rambling bombast, hyperbole, conceit, elasticity with the facts and the truth, humour, bribery: this was energised, unconstrained Trump in his element. He was throwing lumps of raw red meat to the faithful. He was preaching to the converted. He doesn’t give a damn about trying to persuade Democrats: he despises them. But both parties are competing for the critical “swing” voters: with House and Senate outcomes fought on the tightest of margins, it is this fickle, unpredictable constituency accounting for around 10% of the voting public which habitually determines who wins and who loses elections. Even with many headwinds, especially an immensely unpopular war with Iran which Trump started and its related economic inflation, this will still go to the wire.

He promised to pay every American adult “FIVE THOUSAND DOLLARS if the Republicans win the election”. It’s a straightforward political bribe. If it isn’t illegal, it ought to be. If it were honoured it would cost $1.3 trillion. “There is only one caveat, only one caveat, I insist on. You HAVE to spend the money in America! We don’t want you spending it in Canada or Chaiyna!” $5,000 per adult is five times the value of the “stimmy checks” doled out by Joe Biden in the Covid crisis to stimulate growth. It is known among economists as “helicopter money”, by dissenting and dismissive politicians as the “Magic Money Tree”, otherwise more formally by its official title, “Modern Monetary Theory”. However it is styled, it is the economic tactic of the politically “progressive” left, resocialising government (i.e. taxpayers’) money. It is most certainly not advocated or endorsed by economic conservatives. Headline grabbing, certainly, there is no inkling of where the funding would come from.

The Fed is battling to keep inflation within limits. It should be unimpressed at the President’s generosity potentially giving the US demand-side of the economy a one-shot $1.3 trillion adrenaline rush. And in any case, the central bank is supposed to determine the money supply, not the Treasury and certainly not the President on a political whim. Who knows if it will either work or be honoured. Nothing is predictable with this most mercurial, inconsistent of presidents. Time will tell.

The inflation spectre  

But for the markets much the most significant news came in Trump’s now habitual, off-the-cuff press briefing on the airbase apron before boarding Air Force One. The Iran war (and this time he really called it that) will end “Immediately after the election”. Far from ending now, he’s telling us it has a minimum of another two months to go. Many of us already knew that the conflict would be prolonged; but to hear it from the President was a surprising, rare admission that the campaign has been anything other than perfect. He is pinning his hopes on the new economic sanctions bringing Tehran to its knees. He claims the Iranian leadership is only hanging on by its fingernails to try and swing electoral opinions in America that Trump should be dumped. That in his view would herald a “soft government in Washington allowing Iran to have a nuclear weapon”. Unless he has a major change of strategy, one thing is clear: Trump is not in control of events and he cannot determine the result of this conflict unilaterally. His vision of it all being over by Christmas remains optimistic.

Already strong as hostilities resumed, the price of oil jumped again on Trump’s comments. Today at $105 per barrel, Brent Crude is its highest since July and is up nearly 80% since January 1^st. In Europe, wholesale natural gas prices have multiplied by nearly three-fold over the same period. Few countries escape the consequences, including the UK. However, the burden is particularly acute in Germany where households and industry are heavily reliant on gas as their principal source of energy; yet more headaches for Chancellor Merz.

Becoming an acute concern is a global shortage of diesel. Demand remains strong. Supply is being disrupted not only because of the conflict in the Gulf, but also by the Russo-Ukrainian war. Russia is a major producer. Ukraine’s pinpoint strikes on Russian refineries allied to economic sanctions being tightened against Putin are driving diesel prices up disproportionately. This is before winter has even begun when demand reaches its seasonal peak. In the US, this week saw record high pump prices close to $6 per gallon with the obvious effect on transport costs.

Earlier in the summer, we pointed out the inflationary pressure arising from simultaneous perfect storms. War in the Gulf and the closure of the Hormuz Strait (aka “Trump Strait”: “Hey, I gotta get something outta this!” he declared in Dallas to wild applause); the weather-related effects on the harvest; Putin and Zelensky both weaponising wheat in their conflict in Eastern Europe. The consequences are wide and deepening. The effect of the severest El Nino in 35 years potentially extends the pain into 2027.

As well as energy costs, consider other commodity and staples price changes between the start of the war and the end of August: wheat +26%; cotton +43%; rice +45%. Some economists now see inflation possibly accelerating towards 5-9%, rather than remaining within a couple of points of the main western central banks’ target of 2%.

Bond markets bite back; Bessent says, “bring it on!”

The inflationary pressure inevitably brings us to the bond markets. The tension is palpable between markets which provide capital and the central banks which set the benchmark price through the official interest rate. Markets currently believe the inflationary risks are greater than are being perceived by the authorities. At the beginning of March, the US 10-Year Treasury yield was 4.05%; today it is 4.95%; the interest rate has not changed once from 3.75%. Percentages are just numbers, but five percent in the context of US government borrowing costs is both a psychological barrier and a political red line. Bond yields across Europe and Japan are rising too to multiple decade highs.  

“I have asymmetric information. I am the house now. You can bet against me if you want.” You can take the man out of the hedge fund but you can’t take the hedge fund manager’s instinct out of the man. US Treasury Secretary and former hedge fund manager Scott Bessent’s gauntlet-throwing challenge to the markets this week about taking on the Treasury were made in relation to its efforts to support the yen (or conversely, surreptitiously to weaken the dollar). He could equally have been referring to his determination to defend US Treasury prices (i.e. to stop the yield going up); so far, he’s winning the yen/dollar battle but has been losing the fight to contain government borrowing costs. How much financial firepower is he prepared to expend from his Treasury emergency fund to keep that critical 10-Year yield below 5%? Will he die in a ditch to do so? He’s defending his boss who caused the hiatus in the first place. The battle is on.

Investment perspective

Among the Jupiter Merlin Portfolios, for those which do not need to own bonds (Merlin
Worldwide and Merlin Growth), they have none. For the rest which have an equity cap or which have an explicit minimum exposure to bonds defined in their mandates, we have minimised the exposure to sovereign bond volatility and interest rate sensitivity by replacing it with corporate investment grade or high yield credit.

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.

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