What Merz’s Push for Independence Means for Investors

The outcome of the German election has broadly matched expectations, bringing a short-term sense of relief to markets.

However, this relief may be tested in the coming days, as Germany navigates the challenging process of forming a coalition stable enough to deflate claims that the far-right Alternative für Deutschland (AfD) is a credible alternative.

Provided that immediate risk is contained, then the most important factor for investor positioning over the next few months is the clear message from the likely new Chancellor, the centre-right Friedrich Merz, that Europe needs to become more independent of the US. However, that’s only credible if he manages to jolt Europe’s largest economy out of its sclerotic state.

German exporter anxiety

For Merz, this presents a delicate rhetorical balancing act. Europe needs strong leadership to assert greater self-reliance amid the US’s increasingly transactional, ‘America First’ approach. At the same time, he’ll need to navigate potential exporter anxiety back home when it comes to potentially crossing swords with US president Donald Trump. The US last year overtook China as Germany’s biggest export market.

Figure 1. A balancing act: The US is the biggest market for German goods

Source: Statistisches Bundesamt, as at 31 December 2024.

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Does Merz have what it takes to reform the economy?

From an equities perspective, Europe has long been a less efficient market than the US, due to its fragmentation across multiple countries, currencies, languages, and cultures. This creates more pricing discrepancies between similar companies as compared to the US, which lacks such internal divisions.

These inefficiencies create opportunities to exploit. While these dynamics are likely to persist as Europe adjusts to a less integrated relationship with the US, there is also scope for longer biased strategies to emerge.

Whether this is successful hinges on if Germany and Europe grasp the nettle of economic reform. Merz’s strong centre-right rhetoric of deregulation, lower corporation taxes and efficiency may not be everyone’s cup of tea, but, if successful, the German election outcome could, in hindsight, prove to be the best response to the twin challenges of Trump-era trade wars and the resurgence of the far-right.

It will require boldness and abandoning old dogmas. The Christian Democratic Union's (CDU) steadfast commitment to the ‘debt brake’, which limits Germany's central government budget deficit to 0.35% of GDP, poses a significant challenge. Not only does it constrain Germany’s ability to invest in its crumbling infrastructure, but it also complicates coalition negotiations.

In the best-case scenario, Merz’s pro-business agenda could be paired with reforming the debt brake to unlock much-needed infrastructure spending. Such a policy mix could turbocharge Germany’s economic prospects and provide a boost to European cyclicals, particularly in the industrial and technology sectors.

Opportunities in Europe

European assets are strikingly cheap relative to the US, and for good reason. Yet there is the potential for long-term outperformance if only its largest economy can unlock real growth.

In the short term, investors are already seeing movement in specific sectors. For example, defence spending has responded strongly to Europe’s push for greater self-reliance, creating potential opportunities in thematic plays. Investors, particularly those with a more directional approach, such as hedge funds, may look to capitalise on these trends before committing to broader allocations in European markets.

A crucial year for credit spreads

The new US administration has introduced fresh uncertainty into financial markets. With inflation remaining stubbornly above the Federal Reserve’s (Fed) two percent target, investors are cautiously assessing the potential impact of new policies on economic growth and price stability.

This uncertainty has created a challenging backdrop for corporate credit, as lenders and borrowers try to navigate shifting yields and financing conditions. Credit spreads have significantly compressed from their peak in early 2023 — partly driven by the Fed’s rate cuts beginning in September 2024 — and this has exerted downward pressure on overall yields available to investors.

Amid this volatility, the US private credit market has proven a pocket of resilience. Middle-market direct lenders have managed to defend their yield premium by capitalising on structural advantages, including greater flexibility, faster execution and more certainty in completing deals.

The question now is whether spreads will normalise this year and whether direct lenders can continue to offer stability compared to the more volatile and liquid broadly syndicated loan (BSL) market.

A technical imbalance

Tightening spreads can largely be attributed to a technical imbalance: strong demand for collateralised loan obligations (CLOs) and significant capital raised by direct lenders met with a limited supply of new loans. This created a borrower-friendly environment, as institutional investors in the BSL market competed with direct lenders for scarce opportunities. As a result, 2024 saw a record wave of refinancing and repricing activity, with borrowers locking in favourable terms. However, this trend may begin to ease in 2025, as a growing pipeline of leveraged buyout (LBO) activity drives sponsors to bring new deals to market, in order to return capital to their limited partners.

Direct lending resilience

Direct lenders in the core middle market, which serves companies earning US$20-50 million annually, have weathered the compression in spreads better than other segments. By November 2024, spreads on first-lien loans narrowed to 538 basis points (bps) above benchmark rates, down from 602 a year earlier. However, the core middle market saw less compression than large-cap loans, where spreads tightened by 86 bps compared to 60 in the middle market.

Figure 2. Core middle-market lenders have seen the least spread compression

Movement in direct lending credit spreads during 2024

Source: KBRA DLD private data, as at 30 November 2024; three-month rolling averages; first-lien term loans only.

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Market participants also noted a slowdown in refinancing activity towards the end of 2024. Despite compressed spreads, direct lenders have been able to maintain their pricing premium by leveraging their flexibility to renegotiate loan terms in a higher interest rate environment, as well as their speed and certainty of execution, particularly in volatile markets. 

This discipline has been most evident in smaller middle-market loans, where competition from the BSL market is less intense. The growing gap in yield premiums between upper middle-market loans (for companies with earnings of US$50-100 million) and large-cap loans (earnings above US$100 million) highlights this trend.

Figure 3. Yield premiums reflect direct lending discipline across smaller loans 

Source: KBRA DLD private data (three-month rolling averages for first-lien term loans, three-year yield-to-maturity), as at 30 November 2024; BSL and high yield (HY) data from PitchBook LCD yield-to-maturity.

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Looking ahead

The uncertain economic outlook could help support a normalisation in credit spreads and help lenders maintain their pricing power. Risks such as shifts in trade policy (e.g., tariffs), disruptions to global supply chains, immigration policy changes, geopolitical conflict and persistent inflationary pressures are likely to create near-term market volatility.

Furthermore, a potential pick-up in mergers and acquisitions (M&A) after a lacklustre start to 2025 brings opportunities for direct lenders, particularly in financing leveraged buyouts, helping them to reclaim market share from the overheated BSL market.

All data is sourced from Bloomberg unless otherwise stated.

With contributions from Adam Singleton, CIO, External Manager Alpha, Nikolaus Abercron, Portfolio Manager and Senior Analyst, Man Group and Andrew Kurtz, Vice President, Man Varagon.