Defence spending to double in a number of European countries 

The US’s waning appetite for a persistent presence in armed conflicts and defence activities in Europe is forcing the EU to ramp up its own defence spending in order to withstand the open and hybrid clashes with Russia over spheres of influence. This was set out at the latest North Atlantic Treaty Organization (NATO) summit, which agreed to increase defence spending to 5% of gross domestic product (GDP) over the next decade. This would mean that defence spending would more than double in a number of European countries in today’s euros. Defence spending in the five largest EU countries would increase from an estimated EUR 220 billion to almost EUR 590 billion, not accounting for inflation.

The EU’s spending targets are ambitious and should be understood as a political signal to significantly increase spending. We anticipate some erosion and doubt that the spending target will be met by 2035. However, even with generous adjustments applied to the declared intentions, the additional defence spending will be substantial enough to establish a lasting positive spending trend.

Infrastructure investment continues to be a priority

The second area where changes in political priorities in the EU, particularly in its largest member state Germany, promise to lead to increased spending in the coming years is infrastructure investment. The change in government in Germany has shifted the priority of reducing public debt further backwards, making funds available to finance neglected infrastructure investments. As with the intended increase in defence spending, it is reasonable to expect some erosion in the injection of the agreed special funds of EUR 500 billion into the economy over the next decade. However, we also assume that a sustainable positive spending trend will be established. The largest increase in infrastructure spending is concentrated in Germany, which has suffered the most from past neglect, while infrastructure investment in other large EU economies will continue to grow at decent rates, as in France and the Netherlands, or will remain highly dependent on EU funding, as in Italy and Spain.

The risk of inflation due to increased spending is reduced because many German construction companies and other European industries have spare capacity. Additionally, the fact that governments have previously reduced their debts means they now have room to borrow and invest more in public projects without compromising their financial stability. Public spending plans for infrastructure and defence are shifting the EU’s economic policy mix towards a more growth-supportive fiscal policy, reducing the need for monetary policy support in the form of lower interest rates. This changing policy mix is supportive of the euro by improving the interest rate differential. Furthermore, an improving infrastructure could motivate increased foreign investment flows into the EU, creating additional tailwinds for the euro.

How will this spending spree affect the individual asset classes?

Currencies: 

The euro is likely to benefit from the EU’s changing policy mix, as the improved interest rate differential and potential increased foreign investment flows into the EU create additional tailwinds for the currency. 

Fixed Income: 

The fiscal U-turn in Germany affects bond markets through the prospect of a higher net supply of bonds as well as the economic consequences. Germany has sufficient fiscal headroom, and risks of drastically higher yields are limited, as inflationary pressures will not massively reaccelerate. We still see interesting entry points in the medium duration segment, while corporate credit should benefit from reduced downside risks.

Equities: 

While we share the long-term growth upside of the European defence companies, the industry’s further outperformance potential over the short term may be tempered by implementation hurdles and continued reliance on US suppliers. 

Infrastructure: 

We appreciate Germany’s infrastructure plan, since the future burden of insufficient infrastructure would be much bigger than the additional debt. The investments should boost construction companies, which are suffering from low-capacity utilisation. More broadly, infrastructure has become a renewed focus in many countries, underpinning our positive view on the theme. 

What does this mean for investors?

The EU will be spending significant amounts on defence and infrastructure projects over the next decade. Germany is fully on board as well. How fast and how effective this process will be remains to be seen. Enthusiasm remains high, which may lead to intermittent disappointments. In the longer term, we embrace this paradigm shift. From an equity perspective, it supports our call to diversify into European equities while keeping exposure to US equities wherever a suitable equivalent cannot be found.

Find out more about the current investment environment in our Market Outlook Mid-Year 2025.