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Germany鈥檚 chancellor-in-waiting on Wednesday unveiled plans for a major boost in defense and infrastructure spending, contributing to a 3.4% rally in the DAX equity index and the swiftest rise in government bond yields since 1990. Friedrich Merz, whose Christian Democratic Union (CDU) alliance won Germany's recent election, has said his government would do 鈥渨hatever it takes鈥� to fend off 鈥渢hreats to freedom and peace鈥� in Europe, echoing then European Central Bank President Mario Draghi's promise in 2012 to defend the Eurozone during the debt crisis.

Merz, who is in talks to form a coalition with the Social Democrats (SPD), plans to recall parliament to seek approval to free up funds of EUR 500bn for infrastructure spending and exempt defense spending over 1% of GDP from the 鈥渄ebt brake,鈥� a rule introduced in 2009 to cap the government's structural budget deficit at 0.35% of GDP. In addition, the proposal would extend the deficit allowance of 0.35% of GDP to German states (L盲nder), which currently must run a balanced budget, potentially doubling the government鈥檚 borrowing cap to 0.7% of GDP per year. Bloomberg also reported that Germany has called for a relaxation of the EU's fiscal rules to permit higher spending on defense, a notable departure given the nation's historical support of budget constraints.

Market enthusiasm over the proposals extended into Thursday, with the DAX up an additional 1% at the time of writing for a year-to-date gain of 17%. The yield on 10-year German Bunds rose an additional 6 basis points to 2.86%,

The package still needs to be approved by the German Bundestag, with a two-thirds majority required. And given inevitable lags in fiscal policy, additional spending could only start to filter through to the economy later this year and into 2026. But despite these caveats, the bold fiscal plan has the potential to boost growth and support Eurozone assets.

The scale of the fiscal boost could provide a lift to confidence, even before increased spending hits the economy. If this package passes, government spending could increase by around a cumulative 20% of GDP over the coming decade. It would also be the biggest fiscal shift in 80 years, surpassing even spending related to the reunification of Germany in the 1990s. The strong pro-growth signal from the move has the potential to support consumer and business sentiment well before funds start to be deployed. So, the announcement boosts upside risks to our growth forecasts for Germany, and for Europe more broadly. It could also help offset potential headwinds to the Eurozone economy in the event of higher tariffs from the US.

Higher German government spending could add to an already improving backdrop for equities. The rally in the DAX following Merz鈥檚 announcement took the index鈥檚 year-to-date gain to 16%, making it one of the best-performing markets in the world in 2025. Cyclical and defense-related sectors led the rise. Despite this recent rally, German and European equities remain inexpensive in relative terms, with multiple catalysts on the horizon. The new German government is pro-growth and has demonstrated a willingness to reform the debt brake, a move supported by Germany's healthy fiscal situation. The commitment to increased defense spending underscores this stance and may be followed by further investments, especially in infrastructure and renewable energy. After years of underinvestment, we believe higher fiscal spending would be well rewarded by equity markets.

The rise in bond yields presents an opportunity, given German鈥檚 solid fiscal position. Yields on 10-year Bunds have risen from 2.4% last Friday to 2.86% at the time of writing. We believe bond markets have overreacted with respect to the credit risk, and maybe even overstated the technical implications in the form of higher future bond supply. While the precise rollout schedule of Germany's extra spending efforts is yet unclear, we believe it's unlikely to challenge its Aaa/AAA credit rating. Even if Germany were to increase spending to the levels assumed above over the next 10 years, and assuming a moderate growth multiplier, our simulations indicate that the debt-to-GDP ratio would still land in the mid 60% area by 2030 (assuming no other shocks to growth and debt).

We believe the German plans have the potential to improve the investment outlook domestically and for the wider region. Yet, uncertainty remains high, particularly concerning potential tariff risks, which we believe necessitates a selective approach. We continue to recommend gaining exposure to the DAX through structured strategies or, more selectively via our 鈥淪ix Ways to Invest in Europe鈥� theme. Alternatively, we still see the EMU industrial sector as well as EMU small- and mid-caps as Attractive. Regarding fixed income, we view the rise in yields as an opportunity to lock in attractive yields in medium-tenor quality corporate bonds. Additionally, the significant shift in Europe's fiscal stance potentially benefits the euro and reduces downside risks, in our view. However, in the near term, we see risk of a pullback in EURUSD, as escalating tariff threats from the US could weigh on sentiment and limit further upside.

For more on this, read 鈥淓urope鈥檚 fiscal moment,鈥� published 5 March 2025.