Germany's high-stakes federal election is scheduled for Sunday. European stock markets are pricing in a near-perfect result. However, the risk is that investors may be more vulnerable to unpleasant surprises from the election outcome. The German benchmark DAX index and other European stock indices have set new records repeatedly this year.

That is largely driven by hopes that the next German administration would have a strong parliamentary majority and implement long-overdue reforms to revive the economy.

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European shares break record highs

The German stock index has outperformed the US and European peers since the snap election was called. However, some analysts warn of the risks of betting on a definite outcome or underestimate the likelihood of market volatility. Last year's surprise European parliament elections, which toppled the French government and led to a deep sell-off in markets, is a fine example of uncertainty.

Daniel Murray, deputy chief investment officer at EFG asset management, said, "There is a clear risk that the outcome isn't as market friendly as is currently expected." He added, "If there's anything we've learned with regard to election outcomes, it's that they've become much less predictable."

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The German election has given investors hope that the new government will likely relax its tight borrowing restrictions. Friedrich Merz, the Christian democrat chancellor candidate, is leading in opinion polls and has shown a willingness to move away from the 'debt brake.'

However, he has emphasised that Germany must first reduce bureaucracy and spending before contemplating further debt. A coalition including his party's alliance with either the social democrats or the greens — both advocates of increased borrowing — is regarded as the most market-friendly scenario. Investors will keep a close eye on the election outcome amidst a broader market risk of Trump's trade tariffs.

(With the inputs from the agencies)