Politics matter again - market week

Sometimes politics can seem like an irrelevance to investors. Markets can shrug off apparently big geo-political events - war and other upheavals can even boost the economic outlook. Over the three months since the US Presidential election - and this week in particular, however - politics seems to matter again.

Germany at a crossroads

In the spotlight after a dramatic general election this weekend is Germany. As expected, the far-right delivered its best performance since the Second World War, capturing 20% of the vote. It won’t stop the centre-right Christian Democrats from leading a two-party coalition after Friedrich Merz’s party won 28.5% of the vote. But it puts Alternative fur Deutschland a step closer to power.

The good news for Merz was a weaker showing from the smaller parties, including the far-left BSW, which means a two-party coalition can be formed. The bad news is that a blocking minority of other parties could make it harder for him to boost investment, including expanding the defence budget. Doing that and boosting the sluggish German economy will be key to the CDU staying in power.

Despite that uncertainty, the euro and Germany’s DAX index both rose as the election result became clear. Investors are hoping that a new era of fiscal expansion and higher defence spending can help Germany rebuild the advantages it enjoyed during decades in which it enjoyed cheap Russian energy, growing exports markets in places like China and, in particular, a reliable defence backstop from its ally across the Atlantic.

That world appears to have disappeared as America demands that Europe steps up to shoulder the burden of its own defence. Under Donald Trump, the US has prioritised rebuilding its relationship with Russia over its expensive underwriting of European security. Its high-handed treatment of Ukraine on the third anniversary of Russia’s invasion in 2022 is the latest indication that the trans-Atlantic pact of the post-war years is over.

A new world for investors too

This is not necessarily bad news for investors as financial markets focus on a new world of higher spending and greater independence for Europe. Defence-related shares have been the big winners from a region-wide market rally. Bae Systems has doubled in value over the past three years. A recent note from Morgan Stanley highlighted the UK stock, alongside Germany’s Rheinmetall and Italy’s Leonardo as potential winners in the new uncertain world that Trump 2.0 is creating.

The other big winner so far this year has been another previously underperforming market. Chinese shares started rallying last autumn when Beijing signalled that it was serious about kickstarting its economy with new stimulus measures. But the rally accelerated last month when DeepSeek showed that there is a potential Chinese alternative to US artificial intelligence dominance. At the same time, Donald Trump has appeared to soften his tariff rhetoric when it comes to China. For the first time in years, the country looks investable again.

The epicentre of the Chinese stock market rally is Hong Kong, where the Hang Seng index has risen by 17% so far this year. Its tech sector has grown even more impressively, up 31% year to date. Last week strong figures from ecommerce giant Alibaba, with a promise to invest aggressively in AI, boosted shares even further.

• Read: DeepSeek has blown three AI myths apart
• Watch: DeepSeek means deep trouble for US tech

Narrowing valuations

The rally in Chinese shares has started to narrow one of the biggest valuation differentials, that between US and Chinese shares. The average multiple of earnings at which Chinese shares trade has risen by 4 percentage points over the past year.

The rally in UK shares recently has had a similar impact, although as in China, UK shares continue to trade at a big discount to their peers in America. The ongoing, unanswered question is the extent to which the relative undervaluation of shares outside the US is justified by weaker earnings growth potential and lower productivity.

For years, American shares have been more expensive than those elsewhere but this has been justified by faster growth. That looks less certain now. Although US corporate earnings grew by 13% in the year to the end of 2024 expectations for 2025 are slipping. Not so in the rest of the world, where forecasts are edging higher. Perhaps the narrowing of valuations still has a way to run.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of  Fidelity’s advisers or an authorised financial adviser of your choice.