The great revival of Europe's industrials
At that time, he unveiled a plan that would unlock hundreds of billions of euros for infrastructure and defence investments, breaking the prior tight controls on Germany's borrowing limit.
He was planning a 500 billion euro (S$749.9 billion) infrastructure fund to invest in areas such as transportation, energy grids and digital infrastructure. This has now been approved by the German government, to be spent over 12 years. The sum is about 1 per cent of the country's gross domestic product per year.
Merz also drove through a constitutional amendment to exempt defence spending that exceeds 1 per cent of Germany's GDP from the 'debt brake', a fiscal rule limiting budget deficits to 0.35 per cent of annual GDP. This means Germany's defence spending is now virtually uncapped.
In addition, German states, which had been prohibited from taking on new debt, will be allowed to incur new annual debt of 0.35 per cent of GDP, the same as the federal government.
In sum, we expect that Germany's fiscal boost could lift annual GDP growth by as much as 2 percentage points over the coming decade. Since Germany accounts for a quarter of the euro area economy, this alone translates into a 0.3 to 0.5 per cent lift to annual euro area growth.
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In addition, for the wider European Union (EU), the European Commission has unveiled the 'ReArm Europe' plan. This would activate a mechanism to allow countries to use their national budgets to spend an additional 800 billion euros on defence by 2030, without triggering EU budgetary penalties. Given other EU countries have a lower debt capacity than Germany, the implementation of this plan could face more hurdles.
Direct and indirect beneficiaries
Not all the German and European defence spending will benefit Europe. Indeed, the European Commission estimates that nearly 80 per cent of defence purchases made by EU countries since the start of the Ukraine war were from outside the EU, with over 60 per cent from the US alone. With US tariff negotiations in the background, more defence purchases by the EU from the US could be part of a trade deal.
European leaders recognise, however, the need for a massive industrial production ramp-up within Europe itself to be truly capable of defending the region. The aerospace and defence industry in Europe, which comprises 26 per cent of the MSCI Europe industrials sector, would be a direct beneficiary of this increased defence spending.
We expect other segments of the industrials sector – such as electrical equipment, machinery, building products and construction and engineering – to also benefit from greater infrastructure and defence spending.
In total, over two-thirds of the industrials sector would benefit directly from Europe's fiscal boost, while remaining sectors would benefit indirectly from the broader uplift in economic growth.
Sustained earnings momentum
The industrials sector notched up a good Q1 earnings season, delivering a 7 per cent positive earnings surprise. Consensus expectations are for earnings to grow by 10 per cent in 2025, and 12 per cent in 2026. With Europe's fiscal boost kicking in especially in 2026, we expect the multi-year tailwind to support earnings momentum for the industrials sector.
We are also positive on other growth trends that benefit the sector, such as civil aerospace, electrification and sustainable construction. Civil aerospace benefits from strong global air travel demand. Electrification demand is growing from urbanisation, heavy AI investments with significant power demands and the increasing penetration of electric vehicles globally. Meanwhile, global sustainability trends are driving an upgrade to sustainable construction, energy efficiency and green buildings.
Overcoming risks
Valuation of the Europe industrials sector is currently elevated, with consensus 12-month forward price-earnings ratio at 20x, compared to the 10-year historical average of 18x. However, we expect the elevated valuation to be sustained by the strong earnings momentum.
Another risk is that the sector currently generates 27 per cent of sales from the US, which could face tariff headwinds, subject to ongoing trade negotiations. A majority of sector revenue currently originates from outside Europe as well, so a stronger euro could translate into an earnings headwind.
Nonetheless, we are bullish on the sector as we expect investors to be focused on the sustained earnings tailwind and a European industrials revival from greater infrastructure and defence spending.
The writer is senior investment strategist at Standard Chartered Bank's wealth solution chief investment office
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