Can Europe afford its rearmament?

We’d rather see infrastructure investments.

Excerpts from this perspective were featured in a Wealth Briefing article on March 12th 2025.

The memorable speech by JD Vance at the Munich Security Conference has spurred European leaders into action. It has become clear that the US may no longer extend its security guarantee to Europe.

An outburst of activity has followed. Spearheaded by the President of France, the UK Prime Minister. and Chancellor-Elect of Germany, Europeans are searching for new ways to guarantee their security.

The US spends $968bn on defence or 3.5% of its GDP, which accounts for over half of the total NATO budget. The next biggest European spenders in NATO are Germany with $86bn (1.6% of GDP), the UK $81bn (2.1% of GDP), and France $64bn (1.9% of GDP).

Source: https://www.visualcapitalist.com/largest-defense-budgets-in-the-world/

Therefore, it would be very difficult, if not impossible, to fill the gap left by the US in NATO. The three biggest European spenders – UK, Germany and France – did not even account for 1/4 of the US spending in 2024.

Let’s take France, which has roughly the same budget deficit as the US at just over 6%. If France were going to increase its spending on defence from 1.9% to 5%, as requested by Trump, its deficit would exceed 9%, an unacceptable amount.

In fact, any additional spending is already too much. French 10-year Government bond yield jumped last week by 40bps, to over 3.5%. Given the French public debt of EUR 3.3trln or 114% of GDP, an increase of 40bps would account for an extra EUR 13bn of interest, which is equivalent to an additional 20% of the French defence spending in 2024.

Italian 10-year yields also spiked by 40bps to 3.95%. With the EUR 3trln public debt of Italy, representing an even higher 119% of GDP, an additional 40bps of interest is equivalent to EUR 12bn, or over 1/3 of Italian defence spending in 2024.

German yields spiked by over 40bps to above 2.8% last week. Last Wednesday and Thursday was the largest two-day sell-off in German government bonds since the 1970s.

Source: Trading Economics

That means that just a DISCUSSION of more defence spending can increase the ACTUAL cash spending by an amount equivalent to 20-35% of the current defence spending through an increase in debt servicing cost. So, if the defence spending in those countries rose to 5% of GDP, that would not only increase the budget deficit by half, as in France but also explode the interest paid on public debt.

When four months ago we recommended Eurozone bonds in our investment outlook for 2025, we did not foresee an increase in the fiscal deficit in the EU, instead, we commended the progress made after the Eurozone crisis.

Yes, this will benefit to certain sectors of the economy. On Feb.16 we already suggested European defence equities as a trade idea, because it is only natural to expect Europeans to spend their money on defence at home. EUAD, a European defence ETF, is up by 39% in USD year to date.

But we very much prefer the idea of Friedrich Merz increasing infrastructure spending. Unlike nuclear warheads, which hopefully would never be used, infrastructure investments have long-term benefits and are a foundation for sustained economic growth and development. For example, Germany could restart its nuclear power plants, securing lower energy electricity prices for industry, thus improving its competitiveness. (We also recommended nuclear as an investment theme on Feb 16).

In conclusion, we prefer to see infrastructure rather than defence investments in Europe as that would ensure long-term competitiveness of the economy. In contrast, defence will only provide a short-term boost to certain sectors but may increase the borrowing costs, negating the benefit. 

Kirill Pyshkin, Chief Investment Officer, WELREX, March 2025 

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