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Europe without Merkel? Investors think through another 'surprise'

By Marc Jones and Paul Carrel

By Marc Jones and Paul Carrel

LONDON/BERLIN (Reuters) - 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 energized 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.

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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 <.GDAXI> to Portuguese bonds. <PT10YT=TWEB>

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 fueled 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 program 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."

EUROPEAN DNA

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 antidote.

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 year.

POSSIBLE ALLIANCES

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 <EUR6MO=> <EUR9MO=> 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)

 
 
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