Key Takeaways
- The incoming German Chancellor is taking steps to weaken the debt brake and massively increase infrastructure and defence spending.
- Previously heavily reliant on the US – Europe is now looking to bolster its defence capabilities. As it builds up its expertise Germany’s role in the global defence industry could increase significantly.
- A sustained fiscal injection could boost German consumer confidence and encourage spending. The country’s economic prospects have moved from stagnation to steady growth.
- German bund yields have risen, and stock markets responded positively. Tariffs remain a negative but there is uncertainty around how punitive they will be.
Lenin famously said that there are decades when nothing happens then weeks when decades happen. Well that certainly applies to Germany. For decades, Germany has been the most conservative major country in the world when it comes to fiscal finances. It is the only one with a constitutional limit, the so-called debt brake. Yet over the last few days, the incoming Chancellor has used the outgoing parliament to weaken the debt brake and propose a massive boost to spending on infrastructure and defence. It’s not a done deal; various hurdles must be overcome but it’s highly likely to pass and the numbers are huge. Meanwhile, the European Council has proposed a Euro150bn loan scheme, and the Commission is planning to ease the rules on excessive deficits. This is especially important for Italy and France though they are constrained by financial markets which are concerned about their existing deficits, never mind extra borrowing.
It is Germany where the action is. For a country with weak growth and low interest rates, this fiscal easing could make a huge difference. The details are important. Ever since Russia annexed Crimea in 2014, Europe in general and Germany in particular have been ramping up defence spending and it’s already close to the NATO target of 2% of GDP for the European Union as a whole. But a huge chunk of the procurement budget goes abroad, mainly to the US. Having decided that it can no longer rely on the US as a partner, Europe is intending to go it alone. That means spending on domestic production – it’s a tough ask. Europe’s defence sector currently punches well below its weight. Whatever the opposite of battle-hardened might be, it certainly applies to Europe. Europe lacks the capacity to build drones, a crucial ingredient of modern warfare. Nor does it make the missiles to defend against drones. They come from the US. Nonetheless, Germany in particular has great skills in engineering and hardware technology. They could become a major player in the global defence industry.
So, what does all this mean for economies and markets? Raising spending on infrastructure and defence takes time and it’s tempting to conclude that German GDP will be little affected in the short term. That’s incorrect. Germany faces serious structural problems from the end of cheap Russian gas, through to the collapse of the car industry and the lack of demand from China, a key market. German consumers have responded by boosting savings and reducing what they spend. The prospect of a sustained fiscal injection should boost consumer confidence and encourage them to spend. The proposed package from the incoming Chancellor also includes a cut to energy bills and a major improvement in labour market flexibility. So the outlook for the German economy has moved up from stagnation to steady growth. There is even the prospect of a much bigger fall in energy prices over the medium term for Germany and the rest of Europe as the supply/demand balances for natural gas shift.
The bond market has taken notice with a big jump in German bund yields. But they remain low, well below those in the UK and US. And the stock market is delighted.
What about tariffs? Well yes, they are a negative. We’ll just have to see how punitive they turn out to be.
A stronger eurozone economy would benefit its major trading partners, including the UK. But the extra borrowing adds to big deficits in the developed world. This would generally favour equities over bonds. I was trying to remember when I last got this optimistic about German growth …it was 1990, when the country was reunified. The collapse of the Soviet Union gave us a peace dividend then but the re-emergence of Russia as a threat seems to be generating another dividend of sorts.
