Update on ReArm Europe - Economic and Financial Consequences

The urgency to increase EU defence

Released last September, former Mario Draghi’s report[1] urged the EU to revive and boost its competitiveness. At the end of January, the European Commission presented the Competitiveness Compass to allow Europe to revive economic growth and secure prosperity. The report has the following objectives:

• Close the innovation gap with the main competitors
• Link decarbonisation and competitiveness
• Increase resilience in supply chains and enhance cooperation between member states in defence

Uncertain about the US commitment to offer security for Europe, European leaders have recently announced a series of measures aimed at enhancing their own defence capabilities.

Large-scale investment counterbalanced by tariff risks

In a significant policy shift, Germany's centrist parties have agreed to modify their fiscal strategy. They have announced substantial efforts to enhance defence and infrastructure investment. The proposed measures include:

• Exempting defence spending exceeding 1% of GDP from the debt brake
• Establishing a €500 billion infrastructure fund to be spent over the next twelve years

While these fiscal changes represent a notable evolution in Germany's policy, the economic implications remain uncertain.

Concurrently, European Commission President Ursula von der Leyen has declared the Commission's intention to provide fiscal flexibility for member states to achieve a defence spending target of 3.5% of GDP over the next four years. The ReArm Europe plan comprises two key pillars:

• Activate the ‘national escape clause’ to allow member states to increase defence spending without being constrained by EU fiscal rules
• Establish a new EU instrument which can provide €150 billion of loans to member states to enhance their defence capabilities

Overall, across the EU, we think defence spending could increase by up to €800 billion over four years. There are of course implementation risks: as mentioned by Draghi, the industrial base is fragmented and “in the defence sector, common planning comes before common expenditure[2]”. Given also Europe's dependence on imports for military needs, the economic impact is expected to be positive but rather limited (+0.2% per year in growth in the Euro area).

The recent announcements are significant . but the economic support should not be overestimated. Still, risks of a recession have diminished as these measures could mitigate the negative consequences of the forthcoming trade war with the United States: We continue to expect growth in the euro area to be slightly below 1% in 2025.

Positive on German equities and European duration

The recent correction in the US Equity market is being described by investors as ‘momentum turbulence’, driven by rising uncertainty over the Trump administration’s policies on trade, immigration, and fiscal spending. We believe this shift marks, at least temporarily, the end of US exceptionalism. At the same time, Europe is undergoing rapid transformation. Rising geopolitical risks have exposed the EU’s vulnerability to historically low defence spending. In response, the EU is accelerating its push for greater strategic autonomy, with Germany — possessing the strongest fiscal flexibility — taking the lead.In response, we have adjusted our strategy, adopting a more cautious stance on equities globally. We are negative on US equities while maintaining a neutral view on other regions.

Given this shift, we favour German equities, the defence sector, and industries that stand to benefit from fiscal stimulus. The defence sector has significantly outperformed the MSCI Europe Index, rising roughly 60% year-to-date,[3] raising concerns about overvaluation. Despite high valuations, the defence sector should continue to benefit from an earnings ‘supercycle’ fuelled by increased European military spending.

In the short term, a potential ceasefire in Ukraine could trigger profit-taking in defence stocks, while other European equities might benefit from renewed optimism surrounding peace.

On the duration side we continue to view European duration as a strong hedge against the execution risks associated with the EU’s investment plans. European bond yields have risen since late February, reflecting both the anticipation of increased debt issuance and the potential positive impact on economic growth.

We maintain a neutral stance on the euro versus the dollar, including the negative impact of tariffs on economic growth. These factors are likely to counterbalance the positive effects of large-scale investments that we expect will gradually flow into Europe.

[1] https://commission.europa.eu/topics/eu-competitiveness/draghi-report_en
[2] Address by Mr. Draghi – Presentation of the report on the Future of European competitiveness – European Parliament – Strasbourg – 17 September 2024.
[3] Source: Bloomberg. Data as at 12/03/2025.