Will German-led Fiscal Reforms be Transformative for Europe?

Yes, in response to weak growth and a changing defence landscape, taking off the fiscal straitjacket should catalyse a more growth-supportive economic environment within Europe. There will be a direct growth impact as increased government investment is disbursed, some crowding in of private-sector investment, and the potential for further positive growth benefits from subsequent institutional changes that may be downstream of this decision. While the growth impact of this policy pivot may be modest initially at a pan-European level, it reduces the potential of negative outcomes and reaffirms our view that investors should maintain diversified equity portfolios.

On March 18, Germany’s legislature voted to approve a considerable package of fiscal supports. The primary measures are a €500 billion infrastructure fund and exempting defence spending of more than 1% of GDP from the country’s debt brake. While the expected new government of the Christian Democratic Union/Christian Social Union & Social Democratic Party have not yet reached a governing agreement, other pro-business measures, such as tax cuts, are expected. Furthermore, the new Bundestag is still expected to attempt further reform of the debt brake, with the Bundesbank suggesting raising the permissible borrowing figure from 0.35% to 0.9%. There are many variables to consider when attempting to gauge the growth impact of this fresh fiscal stance, such as how much will be spent on defence, how much of that will be domestic versus other EU or non-EU, whether capacity constraints will allow large-scale deployment of the infrastructure funds, etc. There are likely also to be spillover effects, such as the crowding in of private sector investment, because of a clearer and more positive outlook picture being painted for the private sector. Therefore, while forecasts are necessarily imprecise, analysts are generally assigning a growth boost of between 0.5 percentage points (ppts) and 1 ppt to German GDP growth in 2026 and 2027 to these initiatives.

At the European level, plans are also afoot to loosen fiscal policy, albeit for now focussed solely on increasing defence spending. This consists primarily of common borrowing of €150 billion to provide cheap loans to member states, excluding additional defence spending from agreed expenditure paths (referred to as activating the national escape clause) for four years, and increasing the flexibility of existing EU funding to allow it to be directed towards defence. The European Commission (EC) estimates that activating the escape clause would allow an extra €650 billion to be spent on defence were average defence expenditure to rise by 1.5 ppts of GDP. The impact of these policies does not signal a step-change higher in European growth in the near term. Taken together with the German plans, analysts are generally expecting a growth boost for the euro area of between 0.2% and 0.3% from these sources in 2026 and 2027.

Nevertheless, it appears symbolic that the likely incoming German chancellor, Friedrich Merz, invoked the “whatever it takes” mantra made famous by Mario Draghi. Indeed, in addition to Germany’s expansive plans, Merz even suggested extending the EU escape clause beyond the EC’s four-year proposal. With Germany moving so decisively away from rigid fiscal dogmas, the EC looks increasingly likely to apply more sympathetic interpretations of their own budgetary framework. Halting austerity to deliver countercyclical stimulus should improve the return on capital within Europe, encouraging private capex. Increasing levels of both public and private capex would then help to raise domestic productivity. Internal trade barriers, fragmented and underdeveloped capital markets, and onerous regulation have also played roles in dampening productivity growth of course. However, recent political developments have seen fresh impetus given to proposals to reform these bottlenecks.

Euro area equities have been outperforming their global peers since late November, with an outperformance of more than 14% delivered since then in local currency terms and nearly 17% in US dollar terms. In the first instance, this took the form of a relief rally from oversold conditions, as some of the risk premium associated with tariffs dissipated. This was buttressed by positive economic surprises in the form of increased lending as monetary policy becomes more accommodative, an easing of the global manufacturing recession, and expectations of further stimulus in China. The most recent leg higher has been catalysed by news of this shift in fiscal policy.

These moves have seen the relative forward price-earnings ratio of euro area stocks to global stocks rise from 0.7 to 0.8, which remains approximately 8% below its median value. Considering the rapidity of this move, with euro area stocks now in overbought territory, and the imposition of global tariffs by the United States in April looking increasingly likely, chasing this move immediately with an overweight does not appear especially compelling. However, these reforms and their associated boost to activity should be broadly supportive of our overweight recommendation to developed value stocks, which have a greater exposure to cyclical sectors.

In the long run, it may be that the euro accrues the greatest benefit from these reforms. Running a less structurally austere fiscal policy, with the pragmatism to deliver countercyclical stimulus, should take the pressure off monetary policy. A return to structurally positive real interest rates in ‘normal’ times would be an underpinning that the euro has lacked in the post-Global Financial Crisis era. Furthermore, the issuance of fresh common debt to finance the lending portion of ReArm Europe ¹ is a further step towards common issuance being a permanent and growing part of the funding landscape. Such a development would increase the financial stability of the currency union and likely attract more structural international participation once it was of sufficient scale and permanence.

While all the above present a positive base case for these developments, there are also certain risks. For one, affording EU member countries fiscal flexibility for defence spending does not guarantee that it will be used. Such under-delivery remains a concern, given markets have already positioned for stronger defence spending to some extent. This caveat is of most pertinence for those with the least fiscal space currently, notably France and Italy, who may risk a rise in borrowing costs. Indeed, while Germany’s debt dynamics should remain untroubling, the recent rise in bund yields has translated essentially into a one-for-one rise in yields in other member states. It should not come as a major surprise to see debt sustainability in certain countries return as a market talking point in the coming quarters.

Perhaps the most salient takeaway is the re-underwriting of the importance of maintaining diversification within equity portfolios, which has shown its worth over the past few months. Indeed, the average pairwise correlation between equities across different countries has declined precipitously to levels rarely seen over the last two decades. With the United States potentially facing cyclical and policy-induced challenges, retaining regional, factor, and currency diversity within portfolios adds resilience. As these fiscal developments should impart a positive direction of travel for the euro area, the region remains an important building block in that endeavour.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

Footnotes

1. ReArm Europe Plan/Readiness 2030 provides financial levers to quickly and significantly increase defence investment and defence capabilities of EU member states.