Chancellor Angela Merkel was elected to a fourth term on Sunday but her party lost one million votes to the far right and she faces the prospect of constructing a difficult governing coalition with minor parties.

The proportion of the far right vote was "a bit of a shock" given markets were not anticipating any surprises from the election, said Paul Hatfield, global chief investment officer at BNY Mellon Investment Management's Alcentra.

Early indications put Mrs Merkel's Christian Democratic Union/Christian Social Union (CDU/CSU) vote at just 33.1 cent - an 8.5 per cent slump - and the Social Democrats (SPD) led by Martin Schulz at a grim 20.4 per cent - down 4.9 per cent. Those twin results meant the two parties that had dominated German politics for decades only just claimed 50 per cent of the total vote.

The rest of the national vote - in an election where there was a significantly higher voter turnout - was split between a range of minor parties. But the major winner in this group was the far right Alternative for Deutschland Party, or AfD, which grabbed 13.2 per cent of the vote.

'Relatively muted reaction'

Yet analysts expect it will take more than an unexpectedly strong showing from the AfD to cause much consternation to markets, given markets have proved ready to shrug off more acute geopolitical risks such as the renewed tensions between North Korea and the US.

"Given the relatively muted reaction to the many big recent shocks, we don't expect much in the way of volatility as a result of this," Mr Hatfield said.

Yet the AfD is the first nationalist party since the Nazis to enter German parliament and strategists are considering to what degree the risk of rising populism in Europe can be further factored into valuations over the coming months and years.

The German result follows a decision by Britain to leave the European Union in 2016, as well as the narrow defeat of the far right in France earlier this year with the election of Emmanuel Macron to the presidency.

"If the election of President Macron suggested to anyone that populism isn't a threat to the European Union, then today's vote is a wake-up call," Societe Generale currency strategist Kit Juckes said. But he conceded that, in the immediate future, "relatively little may change".

For now, the market reaction to the result has been a mild impetus to sell the euro. It was trading at $1.1933 against the dollar on Monday, compared with $1.1951 at the end of last week.

Political risk premium

It is unlikely "the political risk premium in Europe will retreat in the short term", Credit Suisse global chief investment officer Michael Strobaek said.

"The entry of the anti-European AfD in the Bundestag may even add somewhat to the risk of intensified political antagonisms in Germany, but the traditional German parties are unlikely to engage with the far right any time soon," Mr Strobaek said.

Mrs Merkel will have to undertake an increased level of negotiations and, coupled with large political gaps between the parties, that can mean that government formation is likely to be slow and potentially less stable that previous governments, State Street Global Advisors' head of policy and research Elliot Hentov said.

"Germany has become less predictable as of tonight so markets should take note," Mr Hentov said.

The markets had expected the election to allow a Merkel-Macron partnership to provide further support for the euro, with flow-on benefits for the European equity markets, BNY's Mr Hatfield said.

"The involvement of the AfD may put a cap on that," he concluded.

Mr Hentov agreed. "It was as much a bad night for Merkel as for French President Macron," he said.

European stocks have gained ground this year as an improving economic backdrop has trumped any lingering worries about political risks and the STOXX Europe 600 index is up 6 per cent this year.

Demand-boosting policies

On Friday, the German DAX sharemarket index ended the session little changed but held close to a two-month high. The DAX has outperformed euro zone peers over the past four years to hit a record high in June.

Mr Strobaek said he remained confident solid fundamentals would continue to support European asset prices.

"Looking at equity markets, we feel comfortable with our positive stance on both European and particularly German equities," Mr Strobaek said.

A likely three-way coalition including the business-friendly liberals was, at the margin, beneficial for German shares, he said, particularly for domestically-oriented stocks that stood to gain from fiscal spending and demand-boosting policies.

"Aside from the political backdrop, our positive view on the German equity market is based on the premise that earnings growth and valuations are supportive and the macroeconomic backdrop remains solid," he said.