Quick Bites: Germany On The Mend
Just two months after JPMorgan Chase (JPM) declared American exceptionalism as ‘the broad and dominant’ investing theme of 2025, investors around the world are now looking elsewhere. Instead of riding the wave of US outperformance, they are focusing on the potential impacts of tariff wars and major shifts in US foreign policy. Throughout much of this volatile period, markets in China and Europe have outpaced expectations.
Source: Wall Street Journal
The case for European stocks got a boost last week when the German government adopted a plan to inject up to $1 trillion into its economy, with much of the funds supporting the country’s defence efforts. Germany’s DAX index has risen almost 15% this year, and some investors hope that heavy spending will pull the country out of its slump. Countries across Europe are ramping up domestic military spending as the US signals an increasingly isolationist foreign policy position. As a result, shares of the region’s defence companies are booming.
Friedrich Merz, winner of last month’s German election and the man in line to become chancellor, has pledged to focus on European cooperation after the departing government became increasingly distracted by internal frictions between the coalition’s 3 parties.
The spending plan Merz developed marks a pivot for Germany, which for years preached fiscal discipline to its European neighbours while letting its military wither for lack of investment. The package’s scale dwarfs a €158 billion defence fund floated by the European Commission this month to support military spending in the European Union and fund future help for Ukraine.
A massive military buildup across Europe could achieve what governments have failed to do in years:
- Jump-start a sluggish economy.
- Seed new innovations.
- Create new industries.
Countries from the UK to Germany and Denmark have announced vast increases in military spending to counter Russia’s threats, as the US warns Europe not to take the US’s protection for granted. This could be just what the region needs to support an under-pressure manufacturing sector and unlock new engines for growth and exports. But of course, there are numerous hurdles along the way, including a skills shortage, and the rewards might be unevenly distributed.
Rearmament could require sacrifices in certain areas, such as the social safety net, as the peace dividend Europe benefited from since the end of the Cold War is unwound. However, recent economic research suggests that the benefits of this dividend, primarily used to fund the steady expansion of the welfare state, may have been overstated.
Source: Wall Street Journal
Military spending affects the economy in multiple, sometimes contradictory ways. In the short term, it can employ idle workers and capital and encourage private companies and households to spend and invest. It can also divert state money from potentially more productive uses, push up borrowing costs and crowd out some private investment.
Longer term, research suggests that military expenditure can increase the efficiency of the broader economy. Government defence contracts can foster economies of scale and spur innovations in civilian industries. After all, the internet was built on protocols used in the US Defense Department.
How are investors responding?
According to Morningstar, in the first two months of this year, investors added $2 billion more than they pulled from US-based exchange traded funds (ETFs) that invest predominantly in European stocks. That marks a sharp reversal from the second half of 2024, when over $8.5 billion was withdrawn from those same funds. Meanwhile, the pace of flows into US equity ETFs was slower in the first two months of 2025 than in the last two months of 2024.
Source: Wall Street Journal
Of course, the case for US stocks remains reasonably solid. US companies have strong outlooks and are poised to dominate global markets in the long run, with their leadership in technology and the growth of artificial intelligence as a major tailwind. But the US exceptionalism narrative has become a little long in the tooth, with consumer confidence falling, inflation remaining stubbornly high, and consumers pulling back on all sorts of purchases. Most importantly, US stock price valuations are simply excessive.
Markets around the world are trading at near-record discounts to the US; the Price-to-Earnings (PE) ratio of companies in the Stoxx Europe 600 over the past year is around 18.7x, while it is 24.6x for the S&P 500, according to Dow Jones Market Data. For reference, Australia’s PE is around 17x, and the Hang Seng Index’s ratio is less than 13x
