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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Geopolitical Report for 06/23/2025. I'm Phil Adler. It may be logical to assume that economically speaking as Germany goes, so goes Europe. Confluence Associate Market Strategist, Daniel Ortwerth, joins us today with a profile of Germany's new chancellor and what investors can expect from his leadership. Daniel, let me begin with something very basic.
Phil Adler:How does Germany's economy stand relative to economies of other major countries?
Daniel Ortwerth:Hi, Phil. Good to talk to you again. In terms of gross domestic product, Germany's economy is the third largest in the world. There are the two giants, The United States with a GDP of $29,000,000,000,000 and China with a GDP of $18,000,000,000,000. Then comes Germany at $4,600,000,000,000.
Daniel Ortwerth:Only a little earlier this decade, Japan had the third largest economy, but its economy has been struggling with low growth or even shrinkage for several years now and has slipped to fourth. Just to fill out the top five, India is next in size behind Japan, and it's worth mentioning because India is currently projected to pass Japan later this decade and take the fourth spot and close the gap with number three Germany.
Phil Adler:So while Germany's economy lags The US and China by a lot, it's still significant. Now Germany's new chancellor, I wanna learn more about his background, Friedrich Mertz. He spent years incubating in a traditional postwar conservative environment. What were the political hallmarks of this environment?
Daniel Ortwerth:Phil, the dominant characteristic of this period was the Cold War standoff between The United States and The Soviet Union. Let's remember that for forty five years, Germany was split into two separate countries. One allied with the West led by The US, and the other allied with the East and thoroughly controlled by the Soviet Union. This made Germany the focal point and front line of the Cold War. Like so many countries, Germany had two main political parties during those decades, one with conservative and the other with liberal policies.
Daniel Ortwerth:Chancellor Mertz grew up in the conservative tradition championed by the Christian Democratic Union or CDU. In the CDU's view, the two essential pillars of a secure and prosperous Germany, West Germany at that time, were a healthy environment for German businesses and a strong relationship with The United States. The CDU also advocated social policies that were conservative, which has occasionally played a role in German politics, but it was those two foundational advocacies, prosperous German businesses to support the economy and a strong relationship with The United States to assure security that form the core of chancellor Mertz's traditional political philosophy.
Phil Adler:Now, Daniel, as you point out in this week's report, everything's changing now that The United States is modifying its policies toward Europe and as populism grows on the continent. And you make the point that Mertz cannot use old remedies from the last century to deal with new problems, including a lagging economy. What are the current main challenges for Germany's economy?
Daniel Ortwerth:It has been about five years since Germany's economy entered the current period of stagnation right about the time of the global COVID response. Now COVID response did not cause Germany's problems, but it seems to have brought them to the surface. And we highlight five problems in particular. First, energy costs have dramatically risen because of the loss of Russian natural gas in the wake of the Ukraine war and Germany's own choice to accelerate the phase out of its nuclear power plants. Second, Chinese products have become much more competitive in Germany while the Chinese consumer market has softened, reducing German exports to China.
Daniel Ortwerth:Third, during its prosperous period since the end of the Cold War and reunification in 1990, Germany prioritized a balanced budget or even a surplus over investments in critical infrastructure such as high speed Internet and other features of a high-tech industry. Now the country lags behind global competitors in terms of public investment. Fourth, an aging population, lack of interest in technological fields among the youth, and rising barriers to immigration are choking the supply of qualified people for increasingly critical job skills. And finally, the country's increasingly Byzantine regulations and permitting policies are hampering businesses that are trying to expand or incorporate upgrades into their processes.
Phil Adler:Well, let's focus on one of those problems you just mentioned. How is Mertz attempting to deal with the problem of underinvestment?
Daniel Ortwerth:To face this challenge, he is drawing on his pro business roots by promoting a package of tax cuts, elimination of regulations, and stimulus spending that emphasizes infrastructure renewal and development. The new coalition government he heads is already moving quickly to implement a federal budget for twenty twenty five and twenty twenty six that will include major investments. A €500,000,000,000 special fund has been established to start the flow of these investments, and the government has vowed to pass the laws enabling its use by this summer. The coalition has also drafted a 62 plan to stimulate the economy through the elimination of business related taxes and regulations. These actions occur on the backdrop of legislation passed earlier this year to relax the laws governing the German government's ability to borrow.
Daniel Ortwerth:A 2009 balanced budget amendment to the constitution known as the debt break had placed restrictions on the government's total debt level and the size of the annual budget deficit. Among the changes, expenditures on defense, cybersecurity, intelligence, and civil protection exceeding 1% of German GDP can now be financed with new debt.
Phil Adler:As you mentioned, Germany faces a shortage of skilled labor, but this runs up against another issue, which is rising sentiment against immigrants. This doesn't look like an easy problem to solve. How is Mertz trying to address this?
Daniel Ortwerth:Well, Phil, this is definitely requiring balancing act from the new chancellor. On the one side, his coalition partner, the Social Democratic Party or SDP, has a relatively pro immigration stance. However, the right wing alternative for Germany party, AFD, which took second place in February's election, has a staunchly anti immigration stance. Now the f AFD is certainly not a part of the governing coalition, but its rising popularity fairly represents the position of a significant portion of the population. In fact, the election results do a good job of representing how split the population's view on the subject is.
Daniel Ortwerth:Therefore, Mertz will have to craft legislation that cuts the broad issue into smaller parts, fine tuning the anti immigration approach in order to strike the balance. Since the coalition he leads has a razor thin majority in the Bundestag, Germany's parliament, he must tread carefully.
Phil Adler:As he rose through politics, Mertz was right to count on US support for Germany's defense. But now as The US backs away a bit, Germany must adjust. How is Mertz responding to this?
Daniel Ortwerth:Yet again, Phil, he is trying to strike a balance between competing priorities. The level of ongoing US defense commitment to Europe through the North Atlantic Treaty Organization remains an open question. Although the current presidential administration has expressed concern about the appropriate future level of commitment, it has also stated that it has no immediate intentions to withdraw. Remember that The US currently has about 35,000 military personnel stationed in Germany, and in some ways, its commitment has actually increased in recent years as shown by its increasing troop presence in next door Poland. In response to this uncertainty, Mertz has made strong statements about Germany's need to establish a defense capability that is adequate to the task and independent of US assistance, and he has taken steps to increase funding for the German armed forces.
Daniel Ortwerth:At the same time, however, he is actively engaging the Trump administration to include a visit to the Oval Office to preserve as much of the traditional transatlantic alliance as he can.
Phil Adler:Daniel, something was evident to me as I read in your report about Mertz's background. This is a leader with a with a great deal of experience, not only in government, but also in the private sector, in law and finance during the time he was out of government. And he seems to be flexible as he navigates a new but still positive relationship with The United States. Are you confident in his leadership?
Daniel Ortwerth:Phil, I think the best way to answer the question is to say that I definitely consider him extremely well qualified for the job. Ultimately, leadership skill can be determined and verified only by being tested in the position of leadership and in circumstances that demand its successful use. We shall see his events unfold. However, Mertz possesses an arguably unrivaled combination of education, training, and diversity of experience across a range of historical periods and types of endeavor. His ability to navigate the extremely fractious German political environment of today, gain the top spot, and score some early legislative wins further justify as a measure of confidence.
Daniel Ortwerth:Personally, I was impressed by his Oval Office visit. In a setting that has often challenged the composer of many of its visitors to include world leaders, Chancellor Mertz handled the moment with aplomb.
Phil Adler:And would you say his proposed solutions to the problems we mentioned seem promising?
Daniel Ortwerth:They certainly mark a decisive change from German policy of the recent past. Recent German government have gained characterizations such as fiscally hyper conservative, even stingy, and evasive to any leadership role in Europe. The solutions of the Merits government, if nothing else, promise to be different from the past. If the coalition can hold together, remember, as I previously mentioned, this is a razor thin majority coalition, and there is no guarantee that it will hold together. It will enact far reaching measures that inject money into the German economy and a strong bid for German leadership on economic and defense issues into the broader European geopolitical and economic environment.
Daniel Ortwerth:Only time will tell what effects this will have. Again, remember that Germany has largely been confined to a restricted role in European affairs since World War two. But if Mertz has his way, Germany will take an active role in European affairs as well as its own domestic affairs as we have not seen for quite a while.
Phil Adler:Well, let's get into what this all might mean for US investors. Now investors in European defense stocks have been enjoying the last few months. What are the chances that this will continue and even expand to impact European stock markets as a whole?
Daniel Ortwerth:Phil, I can't speak to the valuations or prospects of any individual stock. What I can say is that these policies are designed to inject a significantly increased amount of spending into the German economy. While the most prominent spending will occur in the defense sector, it will spread across the German economy in areas ranging from infrastructure to energy to high-tech, investments in data centers and information networks. Although Germany will prioritize its own companies for the work to be done, the country will not be able to affect this transformation and expansion on its own, so there will be plenty of opportunity for companies in neighboring countries. This is a rising tide of opportunity for European companies in the industrial sector primarily, but also in materials, energy, and information technology.
Phil Adler:But it will require a lot more government borrowing. Germany will need to issue more bonds to finance the expanding debt needed for defense. What might be the impact of higher German government debt rates?
Daniel Ortwerth:After a long period of fiscal discipline, Germany is now going to dramatically boost its borrowing. Therefore, the supply of German government bonds will substantially increase, which we naturally expect to drive down their prices. Since German bonds serve as a benchmark for European sovereign debt and since this new supply will provide an alternative for fixed income investors who would otherwise buy the debt of other European governments, we expect the policies of the Mertz government to drive down the prices of European long term debt across the board.
Phil Adler:And how might The US government bond market be affected?
Daniel Ortwerth:Phil, there is a possibility that this effect could cross the Atlantic and put downward pressure on treasuries. However, the unique status and role played by treasuries may insulate them. For decades, treasuries have served as the reserve asset for the global financial system almost as a currency for certain types of financial transactions. In these characteristics, treasuries are unique. That means demand for treasuries rises and falls with more than just global investor appetite for low risk assets.
Daniel Ortwerth:The sudden influx into the market of another low risk asset such as German government bonds may or may not affect the treasury market.
Phil Adler:Do you, Daniel, see an opportunity in currency markets in favor of the euro if the dollar weakens as many expect?
Daniel Ortwerth:Phil, I consider currency markets to be the hardest markets in existence to predict. Virtually everything affects them. I can say this. If these policies do take place as we expect, it will significantly and durably increase the demand for lots of things whose prices are denominated in euros. Will that have a positive impact on the value of that currency?
Daniel Ortwerth:It is one factor and a big one at that, but it is just one factor among countless others.
Phil Adler:Daniel, final question. As global trade and defense divisions grow, confluence sees the world breaking into economic blocks. We've talked about this a lot with higher inflation worldwide, a good possibility. And one likely scenario is the emergence of three blocks, one led by The United States, one by China, and one possibly by Russia. Is a German led European block a legitimate possibility, maybe even at the expense of Russia?
Daniel Ortwerth:Phil, that's a great question and a really good one to end our discussion. People often think of global fracturing and block formation in terms of two competing blocks driven by two superpowers, and I think that's because the last time we had a fractured world, the Cold War, that's how it was. However, there have been other times in world history during which we had several competing powers with more than two blocks. That certainly could happen again. Let's take it back to the beginning of our discussion and your first question.
Daniel Ortwerth:Germany has the third largest economy in the world, and that is after a five year period of stagnation. And now its government is getting very serious about rejuvenating itself, not just economically, but militarily and geopolitically. It is well within the bounds of historical precedent and present possibilities for Germany to emerge in the future as the leader of a bloc.
Phil Adler:Thank you, Daniel. This week's report is titled introducing Friedrich Mertz, chancellor of Germany, and you can find a link to the written report on the Confluence Investment webpage, confluencenvestment.com. Today's discussion is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.