Euro Strengthens After German Election, but US Tariffs Cast Long Shadow

• German stocks, led by defense manufacturers, saw strong gains after Friedrich Merz’s conservatives won the election.
• The euro strengthened above 1.05, but prolonged coalition talks and external factors like U.S. tariffs may dampen sentiment.
• Despite the uncertainty, European stocks are at record highs, driven by strong earnings and valuation recovery.

German stocks rose on Monday following Friedrich Merz’s victory in the national election. Although the election outcome provides market certainty, coalition talks and the strong showing of the AfD may delay crucial economic reforms.

The euro strengthened ahead of the election, but investors are watching for developments that could impact the eurozone’s economy.

Euro Stock Surge Follows German Elections

German stocks led gains in Europe on Monday after Friedrich Merz’s conservatives won the national election as expected. The pan-European STOXX 600 index rose 0.2%, with real estate and utility stocks up over 1.5%.

Germany’s blue-chip index climbed 0.8%, boosted by arms manufacturers, while mid-cap stocks surged 2.3% and small caps gained 1.1%.

Defense stocks Rheinmetall, Hensoldt, and Renk rose between 3.3% and 4.3%, driven by expectations of higher military spending. Merz is set to become Germany’s next chancellor, but coalition negotiations could delay key economic reforms and spending to revive the economy after two years of contraction.

The AfD and Left party’s strong showing complicates the formation of a stable government, raising concerns over the timeline for pro-growth policies. Investors are cautious, waiting for clarity on whether the new coalition can implement reforms and also on how the new government will handle issues like tariff threats from the U.S..

In particular, automotive, Germany’s most important industry, may face an increase in prices due to tariffs imposed by the U.S. administration, according to the German Car Association (VDA).

The euro rose above 1.05 against the U.S. dollar in anticipation of the election.

This came after the currency had dropped to slightly above 1.02 on February 3, marking its lowest point since November 2022, following Donald Trump’s announcement of his initial tariff plans, which included a 25% tariff on Mexico and Canada and a 10% tax on Chinese imports.

What’s Next for the Eurozone Economy?

The DAX has hit new highs throughout February, driven by defense stocks amid Ukraine peace talks.

A CDU-led coalition could boost market sentiment in the short term, with the election result providing certainty and pro-growth policy shifts fueling optimism about Germany’s economy.

Experts believe the euro may strengthen as a stabilizing economy could attract investors to German government bonds, pushing up yields. However, prolonged coalition negotiations may dampen sentiment and pressure the euro and stock markets.

Michael Brown from Pepperstone told CCN that political uncertainty could weaken the currency.

“European stock and currency movements are primarily influenced by external factors, particularly developments in the U.S., meaning any market reaction could be short-lived,” he said.

ING expects EUR/USD to stay below 1.05, with risks from potential U.S. tariffs and the ECB’s dovish stance. It may then ultimately return below 1.04 in the coming weeks.

Opportunities for Investors

The Stoxx Europe 600 has outperformed the S&P 500 in the first weeks of 2025, and Germany’s DAX has outpaced U.S. stocks over the last four years.

According to JPMorgan , this highlights an important lesson: the market doesn’t always reflect the economy. Strong earnings and a long-awaited valuation recovery have driven recent gains.

The rally presents an opportunity to reassess portfolios and address home-country biases.

JPMorgan highlighted a 2021 study that found German investors allocated 58% of assets to domestic stocks, despite Germany making up only 2% of the MSCI All-Country World Index. Similar trends across Europe can limit returns and increase exposure to local risks.

With the ECB cutting interest rates, European fixed income presents opportunities for extended duration, while a weaker euro may create attractive borrowing prospects.