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* Polls show SPD's Schulz pulling closer to Merkel
* Investors used to Merkel's generally steady hand
* Change in chancellor could loosen German purse strings
* Uncertainty already reflected in currency options markets
By Marc Jones and Paul Carrel
LONDON/BERLIN, Feb 3 A serious challenger to
German Chancellor Angela Merkel is forcing global investors to
parse another potential electoral surprise - removal of a key
political constant through years of euro zone turbulence but
also an end to Europe's austerity bias.
Martin Schulz's appointment as the Social Democrats' (SPD)
candidate to run against Merkel has energised Germany's
September election race and those in his party daring to think
they could unseat her.
He remains the underdog, but polls show him pulling closer
by the day. One published on Thursday gave just a six point gap
between Merkel's alliance and the SPD. It said Schulz far
outstripped her in one-on-one popularity.
That is an unnerving prospect for some investors now
accustomed to Merkel's generally steady handling of Europe's
rolling crises that has contributed to triple-digit gains from
German stocks to Portuguese bonds.
Just a few weeks ago, Larry Fink, head of the world's
biggest asset manager BlackRock, praised "the moral leadership
Chancellor Merkel and Germany have played in an increasingly
discordant world," adding that he hoped it would continue.
Schulz, a former European Parliament president, though, is
looking to shake things up.
Having seen his party wither during its time as the junior
partner in a 'grand coalition' with Merkel's conservative
alliance, he is vowing to fight for fairer tax rules, higher
wages, better education and to overcome the "deep divisions"
that have fuelled populism.
Financial markets will see that as a nod to loosening the
fiscal purse strings - no problem for a major economy with a
large surplus and probably good for European
stocks, although not so great for bonds if it fuels inflation.
One lesson for investors from 2016 was that political shocks
from the U.S. election of Donald Trump and Britain's vote to
leave the EU did not crash markets. In part that's because
growth-friendly fiscal policies have come to the fore, away from
an over-reliance on maxed out monetary policy.
A change in Germany could also help ease international
strains about its budget and trade surpluses that surfaced again
this week when Donald Trump's trade advisor lashed out at the
boost German exporters gets from a "grossly undervalued" euro.
Another question for international investors will be what
happens to Wolfgang Schaeuble's tough stance on financial aid
for Greece if the veteran finance minister is replaced.
They will want to know if Schulz could end the push for
austerity in Europe and take aim at the European Central Bank's
money printing programme and the sub-zero interest rates that
have been crushing German savers.
"If you read between the lines, the Merkel administration
has been very supportive of the ECB's actions," said Tim Barker,
Head of Credit at Old Mutual Global Investors.
"Were she not to be in power, would that support remain? We
don't know the answer."
Schulz is unsurprisingly pro European.
He told Der Spiegel magazine in 2012 the introduction of
common 'euro bonds' across the single currency bloc would be the
best way to reduce the interest burden on indebted countries in
the south, though he said this was "a theoretical debate" as
northern countries didn't want them.
Greek, Italian, Spanish and Portuguese bonds have all been
underperforming this year on nervousness about ECB policy and
rising anti-euro sentiment several countries including France.
JP Morgan Asset Management's Tilmann Galler said with "European
DNA running through his political career," Schulz might be the
Any rally could easily reverse if it opened the government
borrowing spigot again in peripheral euro zone countries.
"All things being equal austerity equals fiscal discipline,
so if you reverse that, does that open the floodgates of
supply?" said Old Mutual's Barker.
"You have to reassess you starting point for valuation. It
could potentially be quite damaging."
The euro could swing too if Germany does start spending. The
government has faced international pressure for years -
including from the IMF and OECD - to boost economic demand at
home to balance its exports. It had a record trade surplus of
almost a quarter of a trillion euros ($264.10 billion) last
Despite the SPD's excitement about Schulz, his chances of
toppling Merkel are still seen as slim.
Though popularity polls have him pulling neck-and-neck, or
even beating Merkel, personal ratings don't necessarily count
for much as Germany does not have a presidential-style system.
A more significant measure of party support still shows
Merkel's conservatives ahead on 34 percent, with the SPD
trailing on 28 percent.
The gap means that to clinch power, Schulz would need to
team up with two smaller parties - the environmentalist Greens
and the leftist Linke - exploratory talks have been held.
The prospect of a heavily left alliance is already alarming
some conservatives, even if it is a long shot.
"It would endanger everything we have achieved," said
Michael Frieser, a member of parliament for the Christian Social
Union (CSU), Merkel's conservative Bavarian allies.
For market players the unknowns all breed caution.
If Schulz became chancellor and signals a spending drive,
German Bunds are likely to underperform their euro zone peers
said JP Morgan AM's Galler, though the bond market selling would
broaden if the ECB makes a quick move to wind down its aid.
The uncertainty is already being reflected in currency
options markets. Traders have been taking out some bets on euro
volatility around the Sept. 24 election,
although that is also when analysts expect the ECB to announce
the next scale down in its bond buying.
Analysts in UBS's Chief Investment Office expect the euro to
be at $1.20 in 12 months time once the dust has settled though
it could be a bumpy ride if Schulz does win.
"It would be an enormous shock to markets and the political
order of the eurozone," said Sassan Ghahramani, CEO of
U.S.-based SGH Macro Advisors which advises hedge funds.
(Additional reporting by Holger Hansen in Berlin, Edward Taylor
in Frankfurt, John Geddie in London, Graphic by Vikram Subheder;
editing by Anna Willard)