Over the last month, the market conversation has been so dominated by tariffs that it’s been hard to tune into anything else happening in the global economy. This is not to say that the newly implemented tariffs are insignificant, the tariffs are unprecedented and a big deal. But their impact on the economy is uncertain and the reality is that elevated interest rates may ultimately be a bigger drag on the economy.
Markets obviously aren’t happy about tariffs, with the S&P 500 experiencing a 10% pullback from its February 19th high, the first 10% “correction” since October 2023. Most of the damage has occurred amongst the most cyclical areas of the market, and even last year’s technology high flyers. Usually when the US sneezes, the rest of the world catches a cold. But not this time. The MSCI Emerging Markets Index has only pulled back close to 2% during this period. Meanwhile, the MSCI EAFE Index, a proxy for developed markets outside the US, has gained 0.6%. This outperformance has been mostly driven by European stocks, with the MSCI Europe Index rising 1% since February 19th. This is in sharp contrast to US outperformance over the last 15 years (with 2017 a notable exception).
Of course, we’re barely talking about one quarter here, and the question is whether this will be similar to 2017, when foreign stock outperformance faded just as people started thinking about diversification again.
Germany wakes up with a bazooka – A fiscal one
Some background here is helpful. Germany’s constitution has something called a “debt brake,” which prevents the central government from taking on a lot of debt (restricting borrowing to 0.3% of GDP). Germany’s 16 states are also required to balance their budgets and prohibited from taking extra loans. No other major economy has such strict limits on borrowing. These requirements were introduced in 2009, though even before that Germany had a core philosophy that ran against taking on debt (perhaps due to scarring from hyperinflation during the 1920s Weimar Republic). In fact, this philosophy made itself into the foundation treaty of the European Union (EU) as well, with EU countries not allowed to take on debt over 3% of GDP (excluding interest payments).
Arguably, this made the post-2009 recovery tough, especially after the euro debt crisis hit in 2010. Europe was restricted by severe borrowing limits, and the one country with a lot of fiscal space, Germany (which had relatively lower debt-to-GDP ratio), refused to take on more debt. Note that Germany’s parliament made an exception to the debt brake after Covid hit, but this amounted to about 200 billion euros in 2021, which wasn’t enough to help.
Germany’s plight has actually been worse over the last seven years (2018-2024)—it’s barely grown during this time, with real GDP growth clocking in at 0.1% annualized during this period. That’s incredible—the third largest economy in the world has flatlined over the last seven years. The problem is that German industrial production has collapsed since 2017—production is now lower than where it was in 2006.
On top of this, there’s rising fear that the Trump administration may peel away the security umbrella the US has provided for 80 years. There is also the threat of Russia inching closer to Germany’s doorstep if they gain Ukrainian territory amid a US-brokered deal.
All of this is why Germany’s incoming Chancellor, Friedrich Merz of the center-right Christian Democratic Union Party (CDU), announced plans to unleash a massive amount of fiscal spending, mostly focused on two areas, defense and infrastructure. In a breakthrough deal struck with his coalition partners, the Social Democratic Party (SPD) and the Greens, the plan is to “reform” Germany’s debt brake to unleash a fiscal bazooka, including:
- A huge boost for defense spending, with spending over 1% of GDP excluded from the debt brake
- A special 500 billion euro ($544 billion) fund for infrastructure, to be deployed over 10 years for transportation, energy grids, and housing
- Allowing Germany’s 16 states to borrow up to 0.35% of GDP above the debt limit
This is massive and the key here is that it’s not a one-off like during Covid. It’s a sustained wave of fiscal spending, amounting to 10-20% of GDP over the next several years—akin to the US spending $3-$6 trillion of GDP. We could see German defense spending soar to 3% of GDP, which would be more than Germany’s entire fiscal deficit in 2024 (which was 2.8%). For perspective, US defense spending is about 3.7% of GDP, close to an 80-year low. The infrastructure package amounts to about 10% of GDP by itself.
Germany does have a lot of “fiscal space.” Government debt-to-GDP is just about 63%, about half of what it is in the US.
Of course, these plans have to pass through Parliament, but there’s a high likelyhood of that happening. That’s a big deal for the global economy, let alone Germany and Europe. In short, the world’s third largest economy Is planning to unleash a massive, sustained wave of fiscal spending.
Busy And Useful 