Why are we seeing increased interest in European defense?
Europe's security environment has fundamentally changed recently in large part due to the U.S. administration's foreign policy shifts. Washington started negotiations on a potential ceasefire deal with Moscow and Kyiv without participation of Europe even though Ukraine's security is indivisible from Europe's. Washington made clear that, given the current geopolitical realities, the U.S.' focus will no longer be on security in Europe and that European allies must take ownership of conventional security on the continent.
The U.S. also demanded that Europeans bear the overwhelming burden of lethal and non-lethal aid for Ukraine in the future and that European countries provide security guarantees to Ukraine without the U.S. backing, raising doubts about NATO's mutual defense commitments. Most Europeans experienced these U.S. foreign policy shifts as an electric shock, jolting them to action to protect their security interests.
Rising to the occasion, Europe announced an unprecedented set of policies and measures to bolster defense spending. The European Commission launched a EUR 150 billion loan instrument to help EU countries invest in key defense areas. It also reactivated the national escape clause to exclude new defense spending from the EU budget rules, allowing EU countries to spend up to EUR 650 billion on defense without triggering budget penalties. Germany, too, reformed the constitution debt rules allowing open-ended defense spending, about 1.5% of GDP in addition to EUR 500 billion infrastructure fund. The EC president meanwhile has suggested that more EU-wide tools should be available to bolster defense spending if necessary.
Is a unified EU response credible?
Such response by the EU institutions and policymakers is a gamechanger. But it is also an acknowledgment that, with U.S. military backing now in doubt, the defense status quo in Europe is no longer sustainable. I think Europe can build its defense industrial base, but it needs time and the U.S.' cooperation to do so. Timing, obviously, is in short supply given the urgency to help Ukraine hold Russia's military advance on the battlefield. This means capacity to increase defense spending in Europe may be limited near term as the EU won't be able to produce enough weapons and ammunition to replace foreign suppliers.
The U.S. cooperation, on the other hand, is indispensable for Europe's transition to defense self-reliance, which means that the U.S. cannot be excluded from high-end weapons systems procurement. Then there may also be political hurdles that end up delaying deployment of defense funds. Some European countries remain tethered to the U.S. security protection, yet others are opposed to the issuance of common debt to finance defense needs. Such political constraint actually may lead to less optimal spending plans at the EU level. But I think that most of the EU spending is expected to come at the national level.
Which countries are best equipped to increase defense spending?
So, not all European countries have fiscal space to ramp up military spending. Countries like Italy and France and, to some extent, Spain, may be reluctant to accumulate debt even as additional defense spending is excluded from the EU deficit rules. And then it's not a surprise that these countries obviously prefer, as a choice for financing defense, EU common insurance. Fiscally, stronger countries meanwhile, like Poland, Estonia, Greece, already spend about 3% of their country's GDP on defense, so I don't expect much upside to their spending plans. And, so, that leaves Germany as the only European country with significant potential to bolster military spending with potential spillover effect to other European countries.
Would defense funds likely be spent locally or will the EU need to rely on U.S. companies?
According to the European Commission president, the loans from the EUR 150 billion fund will be open only to EU defense companies and those from third countries that sign defense and security pacts with Brussels. At least 65% of the fund would be spent in the EU, Norway and Ukraine. The remainder could be spent on production from third countries that have signed a security agreement. The United Kingdom, however, is expected to agree to a security agreement with Brussels by May, allowing it to be included in this initiative. Excluding the U.S., on the other hand, could complicate trade and security relations with Washington at the worst time possible for Europe. National level, though, purchases of high-end weapons systems from the United States are very likely to continue.
How might increased defense spending influence fixed income strategies across the region?
While the case for European defense stocks is clear, when it comes to fixed income, the picture I think is more complex as the impact of defense spending could be offset by the negative impact on European growth from the trade war just launched by the United States. But, all else equal, any rate rally, especially in Germany, would be an opportunity to sell. And, in terms of relative value, EU periphery spreads remain relatively attractive as issuance from Germany is expected to outpace that from countries such as Italy or Spain.
