Support for current Chancellor Gerhard Schröder and his Social Democratic Party (SPD) has bounced back, slashing the conservative CDU/CSU parties' lead in half. And while Schröder is still unlikely to secure an overall victory, there does appear to be a chance that Merkel will be forced into an uneasy power-sharing deal with the SPD.

With Schröder bouncing back in the polls, it is hardly surprising that investors are getting nervous.

The reason for the powerful surge in the German DAX stock index in recent months had been renewed interest on the part of Anglo-Saxon investors, who hoped that a comfortable majority for a new government under Merkel would provide fresh impetus for much-needed economic reforms, said the financial markets expert of the ZEW think-tank in Mannheim, Volker Kleff.

Markets want Merkel and CDU

Capital Economics analyst Lucy Hartiss agreed.

A CDU-led government, with a majority in both the upper and lower houses of German parliament "is clearly the markets' preferred outcome," Hartiss said.

A Merkel-led administration was perceived to have the more business-friendly agenda, targeting increased flexibility of the labor markets, less bureaucracy, a simplified tax system and incentives to raise direct foreign investment.

And with majorities in both Bundestag and Bundesrat, Merkel would be better able to push through her program of economic reforms.

Center-left has made a dent

However, a re-election of Schröder and his ruling coalition of SPD and the environmentalist Greens would not necessarily be the disaster that many market players feared it would be, Hartiss argued.

"After all, the economy has begun to turn around under SPD management," she said.

"It would be ironic if Schröder were to pay the electoral price for the short-term costs of economic reforms he has implemented just as the long-term benefits are starting to come through," as demonstrated by recent unemployment and industrial output data, Hartiss added.

Furthermore, a CDU victory would still carry risks, such as the prospect of increased social tensions and the likelihood of a rise in sales tax, she added.

Short term vs. long term

ZEW's Kleff also pointed out that a CDU-led government would not be able to overhaul the German economy completely "in a short space of time." That meant there was room for the stock markets to fall back in disappointment.

Furthermore, many reform measures could actually have a negative effect on the economy and on the stock markets in the short term. And the months of September and October were traditionally seen as the weakest for the equity markets, anyway, Kleff said.

Record high oil prices were another negative factor that could weigh on investor sentiment, raising the likelihood of a large-scale correction on the stock markets, he added.

Grand coalition not all bad

Hartiss said that a grand coalition need not be a recipe for policy paralysis.

"History seems to suggest that a grand coalition is not all gloom and doom," she said. "Arguably, the grand coalition of the late 1960s steered the economy out of a recession and implemented both financial and macro-economic reforms.

"The best outcome would be the election of an effective administration committed to continue economic reform," Hartiss added. "This may be almost as likely under a rejuvenated SPD government as one led by a lacklustre CDU."