Economic outlook: What might Germany’s historic fiscal pivot mean for the economy and markets?

The parties that are likely to form Germany’s next coalition government have drawn up plans that could dramatically loosen fiscal policy and increase government spending in the eurozone’s largest member state. In this month’s commentary, our Chief Economist, Colin Warren, looks at how the proposals might impact the economy and financial markets.

What has happened?

Following the election in February, the likely coalition partners in the next government – the CDU/CSU and the Social Democrats – agreed a plan to loosen the country’s fiscal rules and increase spending on defense and infrastructure. Under the proposal, defense spending that exceeds 1% of Gross Domestic Product (GDP) will be exempt from Germany's debt brake, which restricts government borrowing to 0.35% of GDP. Effectively, this will mean that military expenditure will no longer be capped.

In addition, a Euro500 billion off-budget fund will be created to upgrade the country’s infrastructure during the next 10 years, investing in a range of areas including transportation, energy, civil protection, healthcare, and digital transformation.  If the Euro500 billion is divided evenly over 10 years (i.e., Euro50 billion per year) this would equate to just over 1% of GDP a year in additional spending[i] – a substantial sum.

Finally, rules will be changed to enable the German states to take on debt up to 0.35% of GDP. Over the longer term, the parties also plan to reform the debt brake rules to allow higher investment on a permanent basis.

In addition to the initial proposals, a subsequent deal with the Green Party – necessary to secure the two-thirds majority required to change the fiscal rules in the outgoing parliament – ensures that Euro100bn of the infrastructure spending will go on environmental projects, and that taxes will not rise, or other areas of spending be cut, to fund the package.

Why now?

Several factors have converged to prompt Germany, which up until now has been a strong advocate of fiscal discipline, to dramatically loosen the purse strings. Firstly, given the growing threat from Russia, the prospect of reduced US military engagement in Europe from the US administration of President Donald Trump has heightened the urgency for Europe to enhance its defense capabilities.

Moreover, a chronic lack of investment in recent years has resulted in a marked deterioration in the country’s infrastructure, which in turn has impeded economic efficiency and competitiveness. Finally, at a time when the threat of tariffs from the Trump administration looms large, it is hoped that a looser fiscal policy will kickstart growth after years of economic stagnation.

How might this impact the economy?

The increase in spending carries the potential to significantly boost GDP growth going forward, although in the absence of detailed plans, forecasts should be viewed with caution. Some analysts, including those at Goldman Sachs, speculate that the proposals could see German defense spending rise from 2.1% of GDP in 2024 to 3.5% by 2027[ii]. This would be in line with estimates from the think tank Bruegel, which suggests that overall European defense spending would need to rise from 2% to 3.5% to deter Russian aggression[iii].

However, it is important to remember that not all increases in military outlays will translate to an increase in GDP, as a significant portion will be spent on equipment from foreign producers. Analysts at JP Morgan reckon that only 40% of European spending on military equipment currently goes to European suppliers[iv]. This figure could increase and therefore raise the impact of military spending on domestic activity over time as European companies increase capacity.

Indeed, German defense companies are already looking to expand their domestic operations by repurposing plant and machinery in the auto sector, which has been cutting jobs and closing factories amid weak sales and growing competition from Chinese electric vehicles. Rheinmetall, Germany’s largest ammunition manufacturer, recently announced that it was considering taking over one of VW’s plants, which the carmaker is looking to close, in order to produce tanks[v].

These developments have raised hopes that the defense sector could pick up the slack from a struggling German auto industry, which is also vulnerable to possible tariffs from the Trump administration. However, it should be noted that sales in Germany’s defense industry are just around one tenth of those in its automotive sector[vi]. Moreover, in the short term a lack of capacity might limit defense companies’ ability to increase production; Rheinmetall recently reported a significant lengthening of order backlogs in its latest company results[vii].

Increased spending on infrastructure carries the potential to have a bigger impact on GDP growth, given that a greater proportion of government cash is likely to be spent domestically. However, given lengthy planning and approval processes, stepping up investment will take time and will depend upon projects becoming ‘shovel ready’.

Against this backdrop, there is a considerable degree of uncertainty as to precisely how the changes will impact the growth outlook in Germany. However, several major think-tanks, including The Institute for Macroeconomics and Economic Research (IMK) and The German Institute for Economic Research (DIW), suggest that the reforms could lead to a pick-up in annual growth rates to around 2% from 2026 onwards[viii]. This pace would mark a significant acceleration after the recent years of stagnation (the German economy shrank by 0.2% in 2024 and 0.3% in 2023[ix]) and would be higher than the 1.8% average pace recorded during the 15 years prior to the pandemic[x].

Over the longer term, spending on defense and infrastructure could generate technological spillovers and improved productivity that lead to higher trend growth rates in the broad economy. According to a recent report from the Kiel Institute, a 1% GDP increase in military spending could increase long-run productivity by 0.25% both through ‘learning-by-doing’ and increased research and development (R&D)[xi].

What impact might the plans have on the bond market?

Yields on German government bonds, known as ‘Bunds’, rose sharply in the wake of the plan being announced, as investors moved to price in stronger economic growth, less aggressive interest rate cuts from the European Central Bank (ECB), and increased volumes of debt issuance. During the days following the plan’s announcement by Chancellor-in-waiting Friedrich Merz on 4th March, the yield on the 10-year Bund rose by around 40 basis points - the largest increase since Germany’s reunification in 1990[xii].

Looser fiscal policy in Germany, along with separate plans from the EU to increase defense spending[xiii], have prompted forecasters to price in stronger economic growth in the region, which in turn could put upward pressure on inflation. This has caused markets to dial back expectations for future interest rate cuts from the ECB, as investors reason that looser fiscal policy will mean that less monetary accommodation is required. Markets now see the ECB’s policy rate bottoming out at around 2% by the end of 2025, compared to 1.75% prior to Germany’s announcement[xiv].

In addition, expectations of increased bond issuance resulting from the debt-funded increase in government spending has also put upward pressure on bond yields. Some estimates suggest that German debt issuance could increase by more than one trillion euros over the next 10 years, with the country’s debt to GDP ratio potentially rising towards 90% from the current 63%[xv].

At the time of writing, the 10-year Bund yield is trading at around 2.8%, up around 50 basis points since the end of February[xvi]. The yield curve – as measured by the spread between 2-year and 10-year yields – has risen to 63 basis points, its steepest since the summer of 2022[xvii]. Higher yields in Germany have also dragged up yields in the rest of Europe, including in the UK.

Where bond yields ultimately go from here will depend on how the economy actually develops which, given question marks over implementation and the risk of a global trade war, is highly uncertain. However, Goldman Sachs reckon that extra German debt issuance could ultimately result in the 10-year Bund yield trading in a higher range, of 3.0-3.75%[xviii].

Higher long-term rates would increase debt servicing costs for indebted countries and corporations, potentially creating a drag that could partially offset the positive impact of higher spending on GDP growth. Increased debt servicing costs could be problematic for the likes of Italy and France, which have public debt to GDP ratios of 135% and 110% respectively[xix] [xx], and might require offsetting cuts in other areas of government spending.  

What about the equity market?

Uncertainty over US tariff policy and growing concerns over a US slowdown have weighed on global equity markets in recent weeks, but the prospect of increased government spending has helped the German equity market outperform its developed market peers. 

The German fiscal plan has given a significant boost to direct beneficiaries of increased defense spending, most notably arms maker Rheinmetall, whose share price has more than doubled since the start of 2025. Companies that stand to benefit from increased infrastructure spending, such as construction materials company Heidelberg Materials (up 47% year-to-date) and energy infrastructure provider Siemens Energy (up 20%), have also seen big gains[xxi]. Shares in German banks - which are likely to benefit from stronger economic growth, increased lending and a steeper yield curve – have also rallied strongly.

These gains have helped drive a 20% increase in the iShares MSCI Germany equity ETF and a 10% rise in the MSCI eurozone ETF so far this year, easily outperforming markets in the US and Japan, which have fallen back after a strong performance in 2024[xxii].

With increased German outlays also likely to benefit European companies more broadly, and other eurozone member states also potentially set to increase spending, the recent outperformance of European equities could have further to run. Although eurozone equities have outperformed the US so far in 2025, their 188% gain over the last 15 years is dwarfed by the 494% increase in the US bourse[xxiii]. This might suggest that eurozone equities have considerable ‘catch-up’ potential.

The recent gains in Eurozone equities have meant that they are no longer ‘cheap’ historically; the current forward price earnings (P/E) ratio of 14.1 is now above the 20-year average of around 13. However, valuations are still attractive relative to the US (forward P/E of 20.9), even when adjusted for sectoral differences[xxiv].

It will clearly take time for planned increases in defense and infrastructure spending to boost economic growth and, by extension, corporate revenues and profits. And while certain sectors will benefit, there could also be potentially adverse consequences. Higher bond yields mean that companies will face higher borrowing costs than they would have done, potentially ‘crowding out’ some private sector activity.  A narrowing gap between the yields on German bonds and their US counterparts has also triggered an appreciation of the euro against the dollar which, if sustained, will hurt exporters’ competitiveness in overseas markets. Higher bond yields could also start to put pressure on European equity valuations.

Nevertheless, at a time when economic uncertainty in the US is weighing on investor sentiment, a more supportive policy backdrop in Germany and Europe gives grounds for optimism that, during the coming years, the continent’s equity markets can narrow the performance gap that has persisted since the global financial crisis.  

25 March 2025