German Stock Market's "Catch-up Trade" Fizzles: MDAX Lags Behind DAX, €500 Billion Stimulus Difficult to Deliver

English Finance APP has noted that the weak performance of the German economy may seem somewhat counterintuitive, considering the massive stimulus measures injected by the government. However, even billions of euros in expenditures cannot resolve all investor concerns, and Sunday’s local election results have exacerbated one specific worry.

The German Federal Statistical Office reported on Monday that output fell by 1.1% in July, while economists had previously predicted an increase of 0.2%. The June data, which was initially reported as a slight gain, has now been revised to zero growth.

Last year’s bullish logic was not entirely unreasonable, and the market paid a premium in advance. The German government’s €500 billion (approximately $580 billion) spending proposal prompted a 20% rise in the MDAX mid-cap index in 2025 based solely on expectations, and a UBS-tracked basket of stocks benefiting from such expenditure—excluding defense—soared by as much as 65%.

However, this year has become an audit of last year’s frenzy. The MDAX has risen just 5.7%, even lagging behind the DAX’s moderate 6.4% gain. On paper, German mid-caps remain relatively cheap, while the fiscal stimulus beneficiaries have not shown any excess returns. The catch-up trade in German equities has, in fact, stalled.

The first reality check is on where the money has actually gone. The Ifo Institute for Economic Research estimates that 95% of the new debt allocated last year for spending was used to cover routine budget deficits, not for additional investment. Berlin plans to use more than €2 billion of its allocation to plant 700,000 trees, while police stations and clinics remain in need of renovation. Economists warned as early as last year that this fund is financing consumption rather than genuine investment.

Surveys of economists show that Germany’s economic growth is projected at 0.9% this year and 1.1% in 2027. While this is an improvement over the stagnation of the past two years, it is hardly evidence of a robust recovery. Investors were promised roads, railways, and grid construction, but so far, all they have seen are accounting adjustments on paper.

Germany’s excess return expectations for 2025 are facing a reality check

The political capital sustaining market enthusiasm for the expenditure plan is now essentially depleted. Chancellor Merz’s approval rating has fallen to one of the lowest levels on record for his office, with the latest poll showing public satisfaction with his performance at just 15%.

Last Sunday, Saxony-Anhalt held its latest state parliamentary elections. The far-right Alternative for Germany (AfD) party won 44% of the vote, a record high for the party in state elections and just a step away from an absolute majority. Two more state elections are set to take place in the next two weeks.

Morgan Stanley’s chief European economist, Jens Eisenschmidt, wrote in a report last week, “While we still see the collapse of the governing coalition as a tail risk, the likely outcome in this scenario would be a minority government, rather than an immediate call for new elections.” However, should Merz post a weak election showing, it may trigger “leadership considerations.”

Alternative for Germany achieves best state election result in history

What followed is a new wave of energy shock. With the Strait of Hormuz effectively blocked and inventories below seasonal norms, European natural gas trading prices have neared €75 per megawatt-hour, the highest level since January 2023 and more than double the level at the start of this year. Even if prices retreat, the damage is done; higher inflation is sure to erode real incomes and consumer confidence.

The remaining bright spots for German equities are concentrated in artificial intelligence and its related sectors. The defense sector has already peaked and pulled back, and Germany’s traditional industrial core has become a loser; Volkswagen was even removed from the Euro Stoxx 50 this month.

The slide in the automotive industry has cast a shadow over local finances. In Stuttgart, home to Mercedes-Benz Group and Porsche, the 2026 trade tax forecast has been slashed to €700 million from a record over €1.6 billion in 2023. The city has enacted its first austerity budget since 2009. Other municipalities are facing similar constraints, with spending cuts further deepening already difficult economic woes.

Although Germany was named the favorite European market in Bank of America’s fund manager survey this summer, capital inflows have remained subdued. Weak momentum, downward earnings revisions, and worsening management sentiment have relegated Germany to near the bottom of Morgan Stanley’s rankings.

The strongest counterbalance to pessimism is the country’s institutional safeguards. Fiscal plans are enshrined in the constitution, and scrapping them would require a two-thirds majority that no current faction possesses.

UniCredit's chief German economist Andreas Rees wrote: “Overall, we expect more political noise in the coming weeks, but we don’t see Berlin descending into paralysis. Some reform measures might be diluted or delayed until after the end of 2026, but broader reform momentum should be kept on track.”

For now, Germany still maintains an advantage with a debt-to-GDP ratio of 64%. However, plans to add more than €200 billion in debt by 2027, combined with rising interest rates, are weakening arguments about fiscal leeway. Fortunately, the DAX’s international revenue structure means that Germany's domestic challenges are not equivalent to those facing the index as a whole.

Among the major EU countries, Germany has the greatest fiscal leeway

There is still stock-picking potential—including semiconductors, the power grid, and areas where the stimulus funds eventually land. However, options are limited, and trading is increasingly crowded. Betting on Germany's broader market outlook requires investors to back a government seemingly losing investor trust, a country held hostage on energy security by two wars, and an economy whose core business is falling into structural decline.

Even for optimists, this is a test of patience—the funds won’t materialize until 2027, but the challenges are already apparent. This is less a case of a wrongly punished valuation discount and more a reflection of a risk-reward ratio working as it should.