Weekly Comment: German parliament approves €1tn spending plan

Market overview – Richard Carter, Head of Fixed Interest Research

A landmark change in Germany’s approach to public finances received the final stage of governmental approval last week, paving the way for the Eurozone’s largest economy to embark on largescale infrastructure spending.

Incoming chancellor Friedrich Merz used Germany’s outgoing parliament to get the measures — the creation of a €500bn, 12-year vehicle to improve infrastructure and an open-ended commitment to increase defence spending (economists have forecast the need to be in excess of €400bn) — through both houses. The spending commitment is approximately 1% of GDP per year and it is hoped the largescale fiscal stimulus can spark growth following years of economic stagnation.

The move signals a lifting of Germany’s so-called “debt brake”, a constitutional measure that capped the country’s deficit at 0.35% of GDP per year. Recent elections saw strong gains for the far right AfD and far-left Die Linke parties that both oppose a substantial increase in government spending. That’s why the old parliament was reconvened to pass the legislation before the incoming politicians take their seats.

Since the previous government collapsed in November, German equities have been a star performer on the expectation that the cautious fiscal approach since 2009 was about to be abandoned. There has also been sizable moves in the government bond market, as bund yields have moved significantly higher to reflect the expected increase in government debt issuance. The rise in bund yields has been felt closer to home, applying upwards pressure on gilt yields that are being pulled in the other direction by falling yields in the US.

US debt sustainability questions remain

Earlier this month US lawmakers passed a stopgap bill to keep federal agencies funded, averting a partial shutdown. Whereas German borrowing is set to drastically ramp up, the US is more focused on curbing its borrowing in view of its burgeoning debt load.

It is readily apparent that US debt levels are on an unsustainable path over the long-term with debt to GDP levels projected to rise to around 160% in 30 years’ time versus 100% now. The current fiscal deficit is also over 6% of GDP, an unusual position at a time of robust economic growth.

However, it is debatable if there is sufficient political appetite to address these issues at the moment with Donald Trump hoping to extend his 2017 tax cuts. There has been a lot of focus on spending cuts and efficiency drives led by DOGE of late, but it is unclear if these will make a substantial difference to the longer-term outlook.

Foreign investors own around 25% of the US Treasury market, with Japan and China  the two largest single holders. There is a risk that overseas buyers reduce their holdings of Treasuries if they become concerned about the fiscal outlook while higher bond yields in other markets such as Europe could reduce the relative appeal of US assets. It is also important to note that the US has not suffered the warning shot across the bow that the UK had with the Liz Truss mini-budget, so fiscal discipline is not as tight as it may be.

Of course, it is impossible to predict when the US might reach a tipping point for its debt and in the short-term the market is far more concerned about the impact of Trump’s trade policies and the risk of an economic slowdown. Treasury yields have actually fallen so far this year with investors becoming more confident that the Federal Reserve will need to cut interest rates as growth slows.

Also, US bond markets remain the deepest and most liquid in the world so we would expect investor demand to remain strong. But at the same time we recognise that investors may begin to demand a premium in the form of higher yields — especially if there is little effort made to improve government finances. We also believe the Federal Reserve has ample scope to cut interest rates from current levels, while the pace of quantitative tightening (balance sheet reduction) is also being reduced. Talk of external debt restructuring is also probably wide of the mark – at least for the foreseeable future.

Weekly economic announcements:

Last week the MSCI All Country World index gained 0.7% (0.4% YTD) to move back into positive territory for 2025. Central bank updates from the Federal Reserve and Bank of England were generally well received by investors, aiding the recovery from recent selling.

United States:

US equities snapped their multi-week decline to rise 0.5% last week (-3.3% YTD), although tech-based benchmarks continued to underperform by rising 0.2% (-7.8% YTD). Growth stocks also continued to struggle, underperforming value for a fifth consecutive week while large caps lagged small caps.

As was widely expected there was no change in Federal Reserve’s policy rate, maintained at 4.25%-4.5% for a third consecutive meeting. Policymakers indicated that they still expect 50 basis points of rate cuts this year, however at the same time they acknowledged higher inflation expectations and lower growth forecasts. The key takeaway from the messaging was that although economic uncertainty has increased significantly, this has not led policymakers to believe that a higher policy path is warranted just yet.

United Kingdom:

UK stocks rose 0.2% last week (6.7% YTD) as the Bank of England kept its interest rates at 4.5%, as expected. Only one of the nine-member monetary policy committee voted for a reduction in rates, compared to forecasts for a 7-2 split. Inflationary concerns continue to weigh on the mind of policymakers, with strong wage growth in particular a sign that perhaps above target price pressures will persist longer than hoped. The 10-year gilt yield increase 5 basis points last week, ending at 4.71% (up 15 basis points YTD). The pound was little changed on the week, ending at US$1.29.

Europe (ex UK):

The MSCI Europe ex UK index posted a 0.6% return last week (9.8%) YTD. While hopes for a boost in government spending are seen as positive, there remains concerns surrounding planned US tariffs that may kick in at the start of next month. German equities declined 0.4% (15.0% YTD), France added 0.2% (9.1% YTD) and Italy gained 1.0% (14.6% YTD). The euro dipped lower, falling back to US$1.08 to pare some of its recent gains.

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