Germany stands on the brink of a historic policy reversal, with implications that could reshape Europe’s economic and geopolitical landscape. From relaxed fiscal constraints to increased defence spending and infrastructure investment, these shifts signal a paradigm change. Coupled with a potential Ukrainian ceasefire and narrowing growth gaps with the US, Europe may be on the verge of a transformative revival.
The universally accepted opinion of “whatever it takes” is well and truly back as Germany stands on the cusp of an unprecedented policy reversal with wider positive connotations for Europe as a whole. This shift may only be possible with a new chancellor on the horizon. A parliamentary window could allow for a sea change, spurred by Donald Trump’s wake-up call and his public alignment with Vladimir Putin.
A Ukrainian ceasefire appears closer, though it may favour Putin over Volodymyr Zelensky. This development could significantly reduce risk premiums for international investors in Europe.
Before the German election in February this year, there was widespread anticipation that the debt brake – introduced after the 2009 financial crisis to cap deficits at 0.35% of GDP – might be slightly eased. Now, it seems likely that defence spending exceeding 1% of GDP will be excluded from these constraints, significantly expanding fiscal flexibility.
This marks a major shift, further amplified by Friedrich Merz’s announcement of a €500bn, 10-year infrastructure fund. The benefits won’t be limited to defence stocks alone. With a debt-to-GDP ratio of just 62%, Germany has considerable room to manoeuvre – and it should, quickly.
The European Union (EU) president’s ReArm Europe plan proposes €150bn in loans for defence financing and exempts new defence spending from the EU fiscal rules. This change can allow EU countries to use their own budgets to allocate up to €650bn on defence over the next four years.
Germany’s increased spend on defence will encourage peers such as Italy and Spain – who spend circa 1.5% GDP on defence – to step up to the plate.
This reflects the fact that, from just one speech during the recent meeting of allies in Brussels, US defence secretary Pete Hegseth stated that a possible reassessment of the world’s biggest military alliance was on the cards. This raises concerning questions about America’s commitment to the defence of Europe. It also creates the fundamental realisation that the continent may now need to be responsible for its own security.
These new fiscal measures could provide a significant boost to economic growth. Germany is poised to overcome its multi-year languish, Europe is expected to grow above its trend rate, and the economic growth gap with the US will narrow substantially.
According to the Rapid Damage and Needs Assessment commissioned by the Ukrainian Government, the World Bank Group, the European Commission and the UN, the cost of rebuilding Ukraine has been estimated at over €500bn – with an end to the war likely to ease European energy prices.
Additionally, interest rates in Europe, now 1.5% below their peak and forecast to drop below 2%, are expected to outweigh any negative impact from tariffs. Financial markets have been quick to compute the ramifications, with the euro strengthening up a notch and German bund yields rising. Both trends are likely to continue if Germany secures Parliamentary approval.
Europe has a history of coming together during crises and while this instance is driven by pressure from the US, the continent is still moving closer in unity. For example, the EU has just announced retaliatory trade action with new duties imposed on US industrial and farm products, as a quick-fire response to Trump’s increase in tariffs on all steel and aluminium imports to 25%. These EU duties will specifically target key markets in the US while preventing additional damage to Europe. EU officials have made it clear that the taxes on imports are aimed at products made in Republican-held states, as a priority.
Europe’s collective unity can also be seen when we look at stock market performance, which has had a very strong relative start to the year. This included benefitting from record four-week inflows but representing just 4% of the outflows since the start of the Ukraine war.
Despite this, investors remain largely disengaged, with low weightings in European markets. Many believe the best approach is to focus on either extreme value or extreme growth funds, but under current conditions, a balanced middle-ground strategy is more likely to benefit from a broader market recovery.
As stagflationary headwinds grow in the US, less than three months into Trump’s second administration, due to major changes to economic policies, tariffs, tax cuts and spending reductions – Europe is starting to stack up. And in fact, it is on the verge of a historic, longer-term turning point. All aboard a positive passing through the German parliament.
Paul Wild is a senior fund manager at J O Hambro Capital Management. The views expressed above should not be taken as investment advice.