I have spent a fair bit of time in the past few weeks helping (?) my son with a geography project that encompasses plate tectonics, volcanoes and earthquakes. Much of what I’ve learned could be used to describe the shifts in politics we have seen this week.
As talks begin between the US and Russia, this past week has given us plenty of signals over the US government’s policy priorities. With the initial talks between the US and Russia taking place in Riyadh, Saudi Arabia, this week, it marked the the first high level talks between the two countries since Russia invaded Ukraine almost three years ago.
The situation remains fluid. While many European countries are now meeting the 2% of GDP spending commitment under NATO, the reality is this number is likely to need to be significantly higher in the future, putting further pressure on already stressed public finances. In the UK for example, defence spending was 4% of GDP in 1989, today it is 2.3% with a goal of 2.5% by 2030. If the UK was to go back to 1989 levels of expenditure as a share of GDP, it would require an additional £70 billion a year of spending. Some innovative use of the public finances will be needed; there is already talk of common European debt issuance to fund the additional spending.
Europe is clearly in need of strong political leadership, and we may make some progress in that respect this coming weekend with the elections taking place in Germany. The polls this weekend will elect a new parliament, and likely a new Chancellor, with the CDU/CSU party of Friedrich Merz well ahead in the polls of incumbent Olaf Scholz of the SPD party. As usual with Germany, a coalition will be necessary to form a government and this process in the past has taken several months. This time round, the situation may be complicated by the far right AfD party, which is polling around 20% but is unlikely to be part of any government given the other parties refuse to work with them. German politicians face domestic challenges thanks to the weak economy, held back by a manufacturing sector suffering the double whammy of weak Chinese demand and high energy prices. The German economy is in desperate need of economic stimulus, but the constitutional Schuldenbremse (debt brake) has limited the annual budget deficit to just 0.35% of GDP. This contrasts with the current French budget deficit of 6.1% of GDP. The debt brake was introduced after the financial crisis when debt was 80% of GDP; subsequently debt has fallen to around 60% of GDP but the economy has struggled, not least since the Ukraine conflict began and undermined the manufacturing sector’s reliance on cheap Russian gas.
The market will likely respond favourably to a new coalition government that is minded to loosen the debt brake, though this expectation appears to have already become ‘priced in’ with the main equity index in Germany, the DAX, already up just over 12% so far this year.
Onto the slightly more mundane world of the economic data, with the focus on the UK with both inflation and employment data released this week. The UK inflation data saw CPI in January at a 10-month high of 3.0%, higher than expected, thanks to rising food prices, airline fares and the imposition of VAT on private school fees. Services CPI climbed from 4.4% in December to 5.0% in January. Further increases in CPI are likely in the coming months, thanks to higher energy prices. The employment data, which showed the unemployment rate unchanged at 4.4% also highlighted inflationary pressures with average earnings rising by 5.9% in December. In the aftermath of the data, there was no shift in expectations for rate cuts from the Bank of England, with markets still pricing 50 basis points of cuts by the end of the year, though the probability of a cut next month declined further, with May seen as more likely for the next rate cut.
It wouldn’t be a weekly update without a mention of tariffs, and President Trump duly delivered more pronouncements on trade levies this week with his promise of significant tariffs on autos, chips and pharmaceuticals. On autos, Trump said “I probably will tell you that on April 2, but it’ll be in the neighbourhood of 25%”. Referring to chips and pharmaceuticals, Trump said “it’ll be 25% and higher and it’ll go substantially higher over the course of the year”. Trump signalled the later increases were aimed to give companies “a little bit of a chance” to relocate operations to the US. If Trump sticks to the dates he has mentioned, the next six weeks should give a lot more clarity on if the headline tariffs prove to be correct. In early March, the 25% tariffs on Canada and Mexico are due to take effect, followed shortly after by the 25% tariffs on steel and aluminium. Then at the start of April we should see the aforementioned tariffs on autos, chips and pharmaceuticals kick in, along with clarification on the reciprocal global tariffs that Trump has promised. Given the pace of news flow since President Trump took office, I may well need a new keyboard by then!
Source: World Bank, HM Government as at 21 February 2025.
Other Data sources in the commentary: Bloomberg as at 21 February 2025.
