The European fiscal spending theme gains momentum

Last week, both German chambers, the Bundestag and Bundesrat, approved a constitutional amendment with over two-thirds of the votes. This decision allows for a 10-year defence budget and a 12-year infrastructure funding plan. As a result, Germany will now establish: 

• A €500 billion special fund for infrastructure and economic reforms. 

• A defence provision, excluding military spending that exceeds 1% of GDP (from the debt brake). 

This move strengthens the position of the expected ruling coalition of Conservatives and Social Democrats, led by ‘Chancellor-in-waiting’ Friedrich Merz. 

Since the Greens, after negotiations, also voted in favour of the constitutional change, an envelope of €100 billion from the special fund is going to be used for climate-related investments. Tomorrow (Tuesday), the new Bundestag will hold its first meeting. It is then expected to elect Friedrich Merz as Chancellor in April. 

With Germany’s fiscal package and stronger EU cooperation on defence and infrastructure, we increased our exposure to European equities (including UK equities in sterling portfolios). Instead of focusing only on defence stocks, we opted for broader investments for two key reasons. Firstly, defence stocks are expensive and have already rallied a lot. Secondly, increased fiscal spending will benefit many sectors including industrials, financials, technology, healthcare, utilities and energy. 

From a market perspective, as the votes were largely expected, European equities didn’t rise much further last week. In addition, the market may start to get ready to brace for some volatility in the coming weeks, due to the Trump’s administration’s announcement of a looming tariff deadline on 2 April. This is why we maintain a diversified allocation across asset classes and regions. For instance, we strategically hold inflation-protected bonds, gold and broad commodities to mitigate the impact of tariff risks on portfolios. And, more tactically, we overweight short-dated government bonds. 

We also stand ready to readjust our investment strategy as required, and own an instrument that appreciates when equities fall, helping cushion any unforeseen drawdown (where client knowledge and experience, and investment guidelines and regulations, permit). Markets tend to react very swiftly to the news flow as economic, corporate and (geo)political events unfold continuously. Rather than knee-jerk reactions, we seek to maintain composure, anticipating potential developments. 

Last week, the US Federal Reserve (Fed), Bank of England (BoE), Sweden’s Riksbank and the Bank of Japan (BoJ) held rates steady. The Swiss National Bank (SNB) was the only one to cut rates due to low inflation. Let’s take a closer look at each of these decisions.  

Starting with the Fed, slower economic growth, driven by trade uncertainty, is a key concern for the central bank. The inflationary impact of Trump’s policies is still uncertain, so we believe the Fed is in ‘wait and see’ mode. That said, policy uncertainty can weigh on growth, so we don’t think they will wait too long before cutting again. We expect the Fed will slow the pace of balance-sheet reduction in April and cut rates shortly after, probably around the middle of the year. But because of tariffs and prospects of fiscal support, we continue to own fewer US Treasuries relative to our long-term allocation.  

The BoE is in a similar position, with the uncertainty surrounding global trade a likely reason for caution. Despite that uncertainty, BoE Governor Bailey said: “We still think that interest rates are on a gradually declining path”. This aligns with our view that the BoE is likely to cut again this year, bringing rates down to 4% or so.  

Unlike the Fed and BoE, the Riksbank is probably at the end of its cutting cycle after it held rates at 2.25% last week. After six cuts since May 2024, Governor Thedeen’s rhetoric was balanced but he left the door open for rate hikes. In his press conference last week, the Governor said: “we are fully prepared to act” if inflation diverges from the central bank’s forecasts given the recent upside surprises to inflation.  

In Switzerland, the SNB cut rates to 0.25% in response to very low inflation (0.3% in February), making further cuts unlikely unless growth weakens significantly. This means that the EUR/CHF will continue to range trade, as weak growth weighs on the CHF and additional ECB rate cuts limit the euro’s upside potential against the Swiss franc. 

The BoJ is an outlier as it’s in a hiking cycle rather than a cutting one. We believe it may raise rates further to 0.75% this summer amid positive growth and inflation.  

It’s a busy week for inflation, with releases in the US, eurozone, France and Spain all due on Friday. Inflation data is also due in the UK (Wednesday), with investors anticipating a decline in headline inflation to 2.7% year-on-year, down from 3% last month. This should confirm our view that the BoE will cut interest rates again (see above).  

In addition, on Wednesday, UK Chancellor Rachel Reeves will deliver the Spring Statement, outlining the latest fiscal outlook. With the UK economy under pressure from global trade factors and weaker-than-expected growth (though stabilising more recently), markets will watch closely for any signals on government borrowing, spending priorities and potential fiscal tightening. The Office for Budget Responsibility, the fiscal watchdog, is expected to confirm a £15-20bn deterioration in the UK’s fiscal position, raising speculation about further spending cuts. While some new fiscal measures may be announced, most will likely be delayed until 2026.