Much like Ernest Hemingway’s famous aphorism, Eurozone policymaking often exhibits a familiar pattern – reactive, bureaucratic, frankly ponderous at times. But once the political will is reached and the Rubicon is crossed, it has the ability to be seismic, creating a sea-change in markets.
This dynamic was true of the creation of the Outright Monetary Transactions (OMT) tool during the Eurozone debt crisis, the enacting of Quantitative Easing (QE) from the ECB in 2015, and the creation of Next Generation EU in 2020. We see similar characteristics in the latest announcement from Germany about a huge structural change in the German fiscal policy outlook.
Although the programme needs to be ratified and some politicking may remain to get it over the line, the intention is abundantly clear. The package is huge and has taken markets by surprise. Chancellor-elect Merz has announced the intention to set up a EUR 500bn infrastructure fund, split between federal and local spending. Even over the ten-year window, this creates a significant fiscal impulse of potentially over 1% of GDP per year.[1]
Not content to stop there, other announcements included exempting defence spending above 1% of GDP from the constitutional debt-brake (which is currently set as 0.35% of GDP structural deficit) and allowing state and local governments to also run structural deficits of 0.35% of GDP (from a current setting of 0). Put together, even if some of this plan is tweaked during the implementation stage, it is clear that the policy shift is generational.
As one of the Eurozone’s most hawkish members on fiscal policy, we see this shift in emphasis as not only important for Germany but also paving the way for a greater impulse from other Eurozone countries, especially with regards defence spending given changing geopolitical priorities. Put another way, it will now be much harder – and it looks much less likely that they would want to – for Germany to block easier fiscal policy across the continent.
With such a large announcement taking the markets by surprise, the moves have already been significant. But given the scale of the shift in outlook, we believe there is room for this theme to continue to drive markets, with a significant upgrading of the medium-term growth outlook in Germany. As well as having implications for those sectors most likely to benefit from increased fiscal spending, we see this as leading to continued underperformance for German bunds, and an improved assessment of the outlook for the euro as transatlantic fiscal divergence moves towards convergence.
The author is Fixed Income Strategist at Schroders.
