Merlin Weekly Macro: ‘Germany is back!’… or is it?

These are extraordinary times indeed as countries react to Donald Trump. Nowhere has the effect been more pronounced than in Germany.

The Debt Brake: a seemingly intractable political problem…

Last November, labouring under the burden of prolonged economic stagnation, Olaf Scholz’s ‘Traffic Light Coalition’ impaled itself on the fundamental principle of the sanctity of Germany’s national Debt Brake law. The Schuldenbremse renders it illegal, except in a national emergency, for any German administration to present a budget to the Bundestag that includes a budget deficit greater than 0.35% of gross domestic product (GDP). Despite the European Stability Mechanism allowing a maximum deficit of 3% of a member country’s GDP, Germany’s domestic law imposed after the near national disaster during the Global Financial Crisis demands essentially a balanced budget with a maximum self-defined limit little more than 10% of the EU’s rules. How could the country possibly kick-start the economy while fettered by such a legally-binding fiscal straight jacket? The government’s internecine warfare resulted in entrenched, polarised positions which proved irreconcilable.

… magically disappears

Roll forward a mere four months and Donald Trump’s precision-aimed political Exocet straight into the heart of NATO demanding European allies pull their financial weight. If they don’t, he’s out. If loud elsewhere, the detonation in Germany has been deafening. That Christian Democrat Chancellor-elect Friedrich Merz has been able to secure the support needed with which to change the constitution by persuading the recently ousted Social Democrats and their Green partners is a major political feat. Inevitably, there has been much horse-trading along the way, notably with the naturally pacifist and reluctant Greens: their pound of flesh is the demand that in return for concessions on national defence spending, €100bn of the additional spend on infrastructure should be specifically for tackling climate change, and that part of the defence-related expenditure must be allocated for financial aid targeted at countries which have been invaded illegally.

Constitutional change requires a two-thirds majority in favour in the Bundestag. The pressure is on to have the Debt Brake reform vote before March 25th. That is the date when parliament is reconstituted as the 21^st Bundestag to reflect the recent election result. While not guaranteed, Merz is now at least fairly assured he can carry the vote in the soon-to-be-defunct 20^th Bundestag; he knows that with the strength of populist party representation in the 21^st Bundestag, notably from the pro-Kremlin AfD on the far-right and the anti-NATO and anti-defence position of the far-left, that he might not have the numbers in the new legislature. He is risking much by ramming through the initiative on what is a guillotine vote.

His political position is simple: you’re either with us or against us. To the AfD it is the appeal that if they want to see Germany’s national pride restored, that is exactly what he is doing: it is explicit in his statement ‘Germany is back!’; if they persist in voting against or undermining him, the political trap he has laid for them is that it follows that they are not only pro-Russian but anti-German. To Die Linke and other left-wing parties it is that pacifism and defence are not only not mutually exclusive but entirely compatible: to have peace, you must be prepared for war. As one Christian Democrat spokesman said in a Radio 4 interview, this is the centrist parties reasserting the centre of gravity in German politics, implying the marginalisation of the political poles where much of the momentum has been in recent years. Time will tell as to what extent it is successful.

‘Germany is back!’

The headline agreement is a long-term funding pool of €500 billion to be exempt from the normal budget constraints (of which that €100 billion figure above is specifically ear-marked for the Green initiatives and a further €16 billion is to be allocated to the Federal states for local infrastructure expenditure). In addition, 1% of GDP (€41 billion) over and above current annual defence spending is also exempt from the Schuldenbremse to be spent on the military and international ‘invasion aid’.

Germany has a significant military capacity deficit to close before it has armed forces compatible both with the size of the country and the extent of the threat. In 2024 it is estimated to have spent €90.6 billion on defence, 2.1% of GDP, of which 28.7% was on equipment and military R&D. While now technically compliant with the current NATO minima of 2% of GDP (soon to rise to at least 3%) being spent on defence and 20% of the defence budget being allocated to equipment spend, the problem is that every single year since 1995 until after Putin’s invasion of Ukraine in 2022, Germany’s defence expenditure was below 1.5% of GDP, averaging only 1.3%. There is no magic wand that will immediately procure the necessary kit. As German defence contractor Rheinmetall’s CEO said last year, even if the funding is there in full, it will take at least 10 years for Europe to make up the defence shortfall were the Americans to leave the alliance. Huge sums need to be invested in military production capacity before the extra tanks, guns, aircraft and munitions roll off the production lines, or new ships slide down the slipways. But at least it is a start.

While many will be happy that ‘Germany is back!’ (a poll last week says that two thirds of the public are in favour of the new policy), a significant minority will be understandably reticent that the phrases ‘future economic prosperity’ and ‘huge militarisation and rearmament’ are being inextricably paired. As against 90 years ago, today it is demonstrably with good intent to prevent a new conflagration, in the mutual interest of Germany and its neighbours and allies.

Investors recalculate German financial risk

Investors, however, have rapidly recalculated the price of swapping physical for financial risk. The announcement of the proposed changes to the Debt Brake forced the yield¹ on the key German 10-year government bond immediately to rise from 2.39% to 2.88%, the biggest one day move in decades; at 3.2%, 30-year German bonds are at their highest yield since 2011.

For all the talk of the sanctity of the Debt Brake, the reality is that every year since the beginning of the pandemic in 2020, Germany has had persistent annual deficits of not less than 2.5% of GDP (2.8% in 2024). Schuldenbremse allows for the 0.35% of GDP to be breached ‘in emergency’, the definition of which has been severely tested not only in parliament but also in the courts on the presentation of each successive budget since 2021. There has been well-founded scepticism that the German government was cynically hiding behind the exogenous shocks of Covid and Putin’s Ukraine invasion as a smokescreen for loosening fiscal policy for normal government spending. Germany’s government debt has risen from €1.9 trillion (58% of GDP) at the end of 2019 to €2.5 trillion (63%) at the end of 2024. The prospect of adding possibly another €100 billion each year for the foreseeable future which is so far unfunded other than through borrowings has caught investors off-guard.

To contain the financial risk the onus now is on Germany’s new government to demonstrate a) fiscal responsibility with ‘normal’ government spending including introducing comprehensive public sector reform and b) that its new programme of infrastructure and military spending can act as a catalyst for broader recovery and a restoration of economic confidence.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

Footnotes

¹Yield is the rate of interest or income on an investment, usually expressed as a percentage.