DAX continues to dominate, but risks are rising

The German economy is facing numerous challenges, yet its stocks are well-positioned to continue outperforming their competitors.

The DAX index in Germany is performing much better than benchmarks in France and the United Kingdom this year, despite short-term risks, including elections. Any surprises there are likely to reveal downward risk for stocks in the short term.

The domestic automotive industry, one of the country’s largest employers, is struggling with layoffs and declining demand from overseas markets. The economy itself is stagnant, and it remains unclear whether the new government will have the resolve to implement fiscal stimulus on the scale needed to unlock growth.

However, there are also positive signs, such as the U.S. pushing for an end to the prolonged war between Russia and Ukraine. European officials are also working on a plan to increase defense spending, which has already led to a rise in stocks in the sector.

If the elections lead to a positive turn for the German economy, its stocks have significant growth potential. Although German stocks are slightly overvalued compared to those in the United Kingdom and France, their historical dividend growth—a key factor in valuation models—gives them better prospects.

And relative to the size of the economy, investors are far from being enamored with German stocks, despite their growth this year, meaning there is significant potential for further improvement.

For example, investors are paying only around 60 cents for every euro of production in the German economy, which is significantly less than what they are willing to pay in the United Kingdom and France.

European stocks are resilient to the strength of the euro

A weak euro benefits European stocks more than a strong euro harms them, according to statistical analysis. This could become a catalyst for regional markets, given the array of risks facing the common currency.

When the euro weakens, European stocks typically rise more than they fall when the currency strengthens. According to a regression analysis of the last five years, measuring daily movements of the Euro Stoxx 50 index as a dependent variable and the EUR/USD currency pair as an independent variable, the index shows a beta of 1.48 relative to the exchange rate. This means that for a 1% change in EUR/USD, European stocks move on average by 1.48% in the same direction.

However, the relationship is not symmetrical. When the euro weakens, the index rises by 1.59% for every 1% drop in EUR/USD. In contrast, when the euro strengthens, the market response is weaker, with an average increase of 1.38% for every 1% rise in the exchange rate.

This has a logical explanation. A weaker euro helps exporters like LVMH, ASML, and Airbus by making European goods more competitive globally. On the other hand, a stronger euro does not lead to such a large drop in stocks, as lower import costs and consumer resilience offset some of the negatives.

Given that the ECB is likely to cut interest rates more aggressively than the Fed, as well as Trump’s tariff threats, the euro may remain under pressure. If that happens, European stocks are likely to benefit, albeit with increased volatility along the way.

German elections are the next big risk for DAX’s outperformance

Federal elections in Germany could pose a hurdle to Europe’s stock rally

The DAX and Stoxx 600 indices have reached record levels this year, partly due to optimism that the new government in Europe’s largest economy will push through long-awaited reforms and stimulate growth. However, relying on a sure outcome from the elections on February 23 or underestimating the risk of market turmoil could prove hasty. In 2024, European Parliament elections unexpectedly led to the collapse of the French government and a sell-off of local assets.

For investors, the elections raise hopes that Germany may relax its strict debt financing rules. Chancellor candidate from the Christian Democratic Union (CDU) Friedrich Merz, who leads in polls, has expressed readiness to change this mechanism but emphasized that reducing bureaucracy and costs is necessary before considering new debt.

The most favorable scenario for the markets would be a coalition between CDU/CSU and the Social Democrats (SPD) or the Greens, who also support greater fiscal loosening. However, a major risk is the strong support for the anti-immigrant party “Alternative for Germany” (AfD), which could create political uncertainty.

According to a survey by Bank of America last month, Germany has become the most favored stock market in Europe as investors bet on stimulating measures. However, widespread optimism means that any unexpected shock could lead to sell-offs. Growth already seems overheated, with DAX entering overbought territory according to the relative strength index (RSI).