Markets have defied consensus expectations coming into the year. The theme of ‘US exceptionalism’ has unwound abruptly, with global equities outperforming US equities and the dollar depreciating versus almost every other major currency.
Europe, in particular, has had a strong start to the year. The euro has appreciated, and European equities have been the best-performing developed market.
There has been a material rise in policy uncertainty in the US in recent months, much of it related to erratic trade tariff policy. Theory suggests that tariffs should boost the US dollar, as the country runs a large trade deficit, but positioning was very long US assets at the start of the year, which helps explain why US assets have underperformed.
Further complicating the analysis of market internals is the concurrent rise in policy uncertainty and emerging questions regarding the outlook for building data centre capacity for artificial intelligence. The news that the Chinese company DeepSeek has developed a high-quality AI model that significantly reduces the required computing power has influenced the AI theme, which is prominently represented in the US stock market.
One area where there is little uncertainty is that the security umbrella over Europe provided by the US has weakened considerably. European countries have benefited from a ‘peace dividend’ in recent decades, but as the US pivots away from the region, defence spending will have to rise again.
The EU currently spends just under 2% on defence, but with wide dispersion among countries. The recent announcement that Germany will materially increase defence spending has been in focus, as it represents a major shift for Europe’s largest economy.
Germany has relaxed its strict fiscal rules to allow more borrowing for defence. Capital Economics estimates that defence spending in Germany will rise from 2% in 2024 to between 3% and 3.5% in 2026. They also note that most other countries will increase their defence spending by between 0.5% and 1.5% of GDP.
This raises the important question of how much spending on defence will boost growth and lead to further outperformance in equity markets. Capital Economics suggests that a reasonable rule of thumb is that countries borrowing to increase defence spending by 1% of GDP will raise GDP by approximately 0.5%.
Defence companies are poised to benefit from higher defence spending, and stock markets have already moved to reflect this. Some of this spending will go abroad as the money is spent on imports, while some will go to workers at private sector companies, which should help boost the economy. The key for markets is whether this spending will use resources that would have otherwise been used for more productive purposes or if it will create positive spillovers.
There is academic evidence that defence spending can support the real economy, particularly through research and development (R&D). The internet, GPS, jet engines and satellite communications are all examples of new technologies that were initially supported by government defence spending.
A 2019 National Bureau of Economic Research paper found that a 10% increase in government-funded R&D could generate an additional 4.3% in privately funded R&D. Europe has a smaller technology sector than the US but boasts some very high-quality manufacturing businesses. The primary purpose of defence spending is to defend the country, but there should be additional benefits if this spending can be structured efficiently.
The circumstances are far from ideal, but the irony is that economists have been calling on the German government for years to relax its strict spending rules to help boost economic growth. The US government has run large deficits in recent years, which is likely a contributing factor to the outperformance of US equities.
Germany has significant capacity to borrow more money, but this is not the case for all other European countries. This challenge will have political ramifications, especially as it may lead to further rises in bond yields.
There are a lot of dynamic variables at play when considering whether the shift in defence spending will lead to sustainable outperformance for Europe. In addition to defence spending, Germany plans to increase infrastructure spending by €500 billion. Higher exposure to technology and higher government spending have supported US equities, but it now appears that we have reached a regime shift on the relative fiscal spending.
AI is likely to have a transformative effect on many parts of the economy. Still, European outperformance will require this broadening in market performance beyond a handful of mega-cap US stocks to continue.
Sentiment and positioning have become very skewed in favour of the US, and some of that has now unwound.
After 15 years of almost uninterrupted US outperformance, many investment portfolios are significantly exposed to US assets. A more uncertain policy environment in the US may encourage investors to diversify away from US equities. Defence spending alone is unlikely to provide a path to sustainable outperformance in Europe, but at least there is now a pathway.
Nicholas Rilley, CFA, is an investment manager and strategy analyst at Butterfield Bank (Cayman) Ltd.
Disclaimer: The views expressed are the opinions of the writer and, whilst believed reliable, may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
