Flash update - Germany, Europe and the US - March 2025

Aviva Investors Multi-Asset Team

We believe the news of the last 10 days has been significant, justifying some important adjustments to portfolios. We believe we are seeing the emergence of a fundamental shift in Europe's stance on spending, in particular on defence, as well as an approach to US economic policy which is much less supportive of equity markets than in recent years. While these are early days for what could be long-term themes, we have been making tactical adjustments to portfolios.

What happened?

• Last week, German leaders proposed to amend their constitutional “debt brake” which places limits on fiscal deficits.  It is thought this will allow unlimited borrowing for defence spending above 1% of GDP. Additionally, it is proposed that €500bn will be allocated for infrastructure spending over a timeframe of c.10 years. This fiscal regime shift is marked as a once-in-a-generation policy change in a region which has struggled to maintain growth in recent decades.
• This shift comes amid a broader European defence paradigm change following President Trump's refusal to offer US security guarantees. The EU proposed to allow member states to increase defence spending without triggering deficit rules, as well as issuing a new instrument that could provide €150bn in defence investment loans.
• At the same time, the economic outperformance of the US, which has been a key driver of superior investment returns in recent years, is now open to question.  Tariff policy was expected to be an area of intense activity for the new administration, but it is becoming clear that this is more than a short-term negotiating tool with key partners such as Canada, Mexico and the EU.  The measures, and the accompanying language, point more towards a goal of resetting international economic relations – with a sanguine approach to the disruption for US companies and consumers.
• Perhaps the biggest surprise of the new administration has been its radical approach to shrinking the state, with Elon Musk’s Department of Government Efficiency leading drastic changes such as employee layoffs and departmental closures.  While the cost reductions will likely be far lower than promised, the chilling effect on household and consumer confidence is in our view material.

What happened in markets?

• On 5^th March German bunds saw their biggest daily jump in yields since German reunification in 1990, as investors started to anticipate a new wave of spending and higher inflation.
• There was also a surge for European equities, with the German stock market (DAX) up +3.4% on the day, though the market has been volatile since. The European Aerospace and Defence Index reached a peak of +34.4% YTD following the news.
• In contrast, the S&P500 has been on the back foot in recent weeks.  It has fallen by almost 10% since its February peak. Major banks have negatively revised US growth expectations for 2025 though we believe this process has further to run.

What is our current portfolio positioning?

• Our current House View round has focused on these changes and their medium-term implications.  Based on the analysis presented and debated, we have adjusted portfolio positions.
• We have made meaningful reductions in equity positions, from a peak of 3% overweight earlier in the year to marginally underweight today.  The bulk of the reductions have taken place from North America, including Financials and broader market exposure, and we have closed positions which anticipated US outperformance of Emerging Markets.
• Anticipating European bond yields to keep increasing due to greater spending and anticipated inflation, we have sold German Bunds and retained underweight positions in France.
• We have further increased our overweight position to Gilts. Given the changes in fiscal policy outlook for the US and Europe, the UK now appears to be one of the more fiscally disciplined DM economies.  The recent commitments to higher defence spending were fully funded through reductions in overseas aid budgets. We also understand that the Chancellor is responding to a loss of estimated fiscal “headroom” by reducing other departments’ budgets.  This, coupled with weaker private sector confidence and spending in the UK, strengthens our view that the UK may cut rates more aggressively than expected.
• Within FX, we are currently underweight GBP for similar reasons. Weaker macro prospects in the UK may prompt the BoE to cut more aggressively, putting downwards pressure on the Pound.

Please note this note reflects our portfolio positioning as at 14th March 2025. Tactical investment positions within the portfolio are subject to change in response to the evolving geopolitical and macro environment. We continuously assess our positions and adjust to identify opportunities and mitigate potential risks.

Key risks

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