The European Commission unveiled its long-awaited “Buy European” rules on Wednesday – aimed at boosting domestic production and competitiveness in key strategic sectors in the face of intense international pressure and the changing geopolitical environment.

The “Industrial Accelerator Act” sets out new rules under which EU governments must prioritise European production in public contracts across defence, digital and industrial sectors. It does this by setting minimum targets for European-made parts that specific strategic and/or energy-intensive products must include to benefit from government subsidies or procurement contracts.

The sectors affected include everything from renewables, batteries and cars to aluminium and cement. Electric-vehicle makers must ensure 70% of components are EU-made, for example. There will be conditions for foreign direct investors to transfer intellectual property and employ local workers. The end result – if the policy is enacted and works as intended – will be a redirection of the bloc's €2 trillion worth of public procurement towards its own industries and firms.

‘Buy European’ – will it work?

The ‘Buy European’ strategy is part of Europe's response to what French president Emmanuel Macron described last month as a “geopolitical and geo-economic state of emergency”. If the continent does not invest in its economy and lift barriers to growth more quickly, it will be “swept aside” by US technology and imports from China, he said. Addressing the root causes of Europe's relative economic decline has become increasingly urgent since the Covid pandemic and soaring energy prices following Russia's invasion of Ukraine laid bare the continent's vulnerability to supply shocks.

And promoting home-grown industry will help protect the EU's €2.58 trillion manufacturing industry in the face of high energy prices, cheap imports from China and elsewhere in Asia. Donald Trump's volatile trade agenda, anti-European rhetoric and hostile threats to cut off trade with Spain over its opposition to war on Iran have made the question more pressing. It is time, says Stéphane Séjourné, the EU's executive vice-president for prosperity and industrial strategy, for Europe to stand up for itself.

Is the whole of the EU behind this ‘buy European’ idea?

There have been disagreements. France was the prime driving force behind the new rules. Germany took a lot of convincing – along with the Netherlands and Sweden, among others – arguing for an approach more inclusive of key trading partners (including the UK). Even this week, the haggling went right up to the wire. Now the final agreed text will be subject to approval by the 27 EU states and the European parliament before becoming law – and there may well be plenty of wrangling to come.

Will it work?

It will be difficult, says Pierre Briançon on Breakingviews. The new rules are an attempt to “deal with the paradox that the bloc's ambitious green industrial policy risks shrinking its manufacturing base”. Given Donald Trump's aggressive America First agenda and that China subsidises its industry to the tune of 4% of annual GDP, the EU has good reason to shore up its manufacturing base.

But the “buy local” idea is also fraught with risks. Unless non-EU members such as the UK and Norway are included, the plans risk turning into a series of hostile trade measures against close partners. It's also important for the EU not to shore up “lost causes”, such as the solar-panel industry that long ago became dominated by China.

And the rules will need to be “implemented and tested with pragmatism”, and open to revision if the results are underwhelming, or if the impact is that European cars (for example) get more expensive and exports suffer. “Brussels will need to act with flexibility and subtlety – two qualities seldom associated with the bloc's enforcement police.”

What else should Europe do?

European “independence” encompasses everything from defence to financial markets. On defence, Macron made a historic offer this week to station French nuclear assets in Germany and several other European countries, as well as inviting them to take part in joint nuclear exercises and support missions.

It's the most important revision to France's nuclear doctrine in a generation – a welcome step towards the same commitment Europe's other nuclear power, the UK, already extends to Nato members.

On financial markets, the French president echoes the recommendations of Mario Draghi's 2024 report on European competitiveness, calling for common European bonds – drawing in part on Europeans' high savings rate – to boost investment in defence and security, green technology and AI.

Why is that so important?

Because without them Europe is “working backwards”, says the Spanish business minister Carlos Cuerpo in the FT. “We are debating defence, security budgets, industrial policy, digital sovereignty and energy grids without the one thing that would make them all affordable: a collective form of credit that the world trusts.”

Nor could there be a better time to create Europe's answer to US Treasuries. With US leadership and stability under question, global portfolios are diversifying rapidly and investors are looking for high-quality, liquid safe assets. Since 2025, the euro has appreciated 15% against the US dollar. But “we are getting a stronger currency without the strategic dividends it should deliver: cheaper financing, deeper liquidity and greater financial stability”.

To do this will require a broader financial infrastructure, including the creation of futures and derivatives markets that allow institutional investors to hedge. And it will require iron discipline and determination on the part of politicians. The changed world has made this an existential question for Europe.

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Europe presents a mixed backdrop, with varied political priorities and differing fiscal positions across major economies. Yet many European companies are global leaders in their fields and continue to grow despite muted domestic GDP and new US tariffs. These firms often generate earnings well beyond Europe’s borders, operate in niche markets where expertise matters and provide essential products and services that remain in demand regardless of short-term uncertainty.

The European Opportunities Trust (EOT) invests in a focused number of “special” European businesses that the manager believes have limited downside and can grow consistently over many years. The trust looks for companies with strong competitive positions, global reach and business models that remain relevant through economic cycles, resulting in a portfolio that differs significantly from the index, the MSCI Europe. The following examples illustrate some of the qualities that EOT looks for in its investments.

Three European companies to consider

Gaztransport et Technigaz (Paris: GTT) designs specialist containment systems used in the transport and storage of liquefied natural gas (LNG). GTT’s technology is used in most of the world’s largest LNG carriers, reflecting decades of engineering expertise and strict safety certification standards that competitors have found hard to replicate. Global demand for LNG is expected to continue rising in the years to come.

Following the lifting of the US moratorium on new LNG developments, 10 major liquefaction projects have now been approved worldwide, six of which are in the US. This should translate into a surge in demand for new LNG carriers fitted with GTT technology. We view this long wave of investment in LNG projects as a structural tailwind rather than a short-lived cycle.

Ryanair (Dublin: RYA), Europe’s leading low-cost airline, continues to deliver impressive growth. The company maintains the lowest cost base of any major airline and has widened its lead over rivals. The company has a strong balance sheet, allowing it to own rather than lease its aircraft, and to standardise its fleet and optimise maintenance practices, all of which contribute to keeping a lid on costs.

This creates a virtuous circle, whereby Ryanair can make bulk orders of next generation aircraft, which carry more passengers with better fuel efficiency. This cost advantage enables Ryanair to offer lower fares, attract more passengers and fill planes consistently, even when consumers’ budgets are tight. We see Ryanair as a structural winner in European aviation. The business continues to gain market share and remains resilient despite higher interest rates, elevated operating costs and fluctuating economic conditions.

Genus (LSE: GNS) is a global leader in animal genetics, helping farmers improve herds’ health and productivity through advanced breeding programmes. One of the most important long-term developments for the company is the US regulatory approval of its PRRS-resistant pig. PRRS, or porcine reproductive and respiratory syndrome, is a costly viral disease that weakens young pigs and disrupts breeding herds, leading to substantial losses across the industry.

A resistant herd can materially improve survival rates, yields and overall efficiency, offering producers clear economic value. Further regulatory approvals in the coming years are expected to be followed by commercial adoption. The scale of the US market and the global prevalence of PRRS provide a strong foundation for durable growth.

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JPMorgan Chase could have chosen Paris, Frankfurt or even Amsterdam. Yet the giant US bank has decided to build a new £3 billion European headquarters in London’s Canary Wharf instead. That is a huge vote of confidence in London and the City at a time when faith in the British economy has reached its lowest point in recent memory. It is also a sign that the Brexit wars have finally been won – and the City will remain the key financial hub for Europe.

Given the UK’s recent dismal track record of delaying any kind of new project, and allowing costs to escalate with dozens of unnecessary regulations, it may be a few years before the diggers and cranes actually get to work. Even so, with 12,000 square feet of space, it will eventually be a huge addition to the Wharf’s existing floor space and it will be home to 12,000 staff, making it the bank’s major hub for Europe and the Middle East. Canary Wharf has been struggling since the pandemic as firms adapted to working from home. A major new tower will boost the Wharf after a difficult few years.

In the aftermath of the UK’s departure from the EU, Paris and Frankfurt, with the help of officials in Brussels, made a huge effort to replace London as the key financial centre for the continent. In Paris, president Emmanuel Macron introduced special tax deals for bankers fleeing across the Channel, and the French regulators even translated all their forms into English to make the paperwork easier.

Meanwhile, Frankfurt created promotional videos selling the lifestyle to be enjoyed there to London-based finance workers. Huge amounts of money and energy were poured into the campaign and there was lots of speculation that one or the other would become Europe’s main financial centre, with London reduced to little more than a regional outpost.

We don’t hear very much about that any more, and for good reason. In reality, both cities have become less appealing over the last few years. The bankers who moved to Paris have found that promises of lower taxes have turned out to be illusory. With a huge deficit to finance, the French government is desperate to raise money any way it can, and “the rich” are an easy target. It has already introduced extra taxes on anyone earning more than €250,000, hardly a fortune at JPMorgan, and it is now threatening a wealth tax as well as a plan to force the rich to “invest” in government bonds at zero interest.

The country is so politically unstable, it is hard to know what might happen next. But one point is clear. It would be a very risky place to locate a major banking headquarters right now.

The Brexit wars have been won

Germany is not much better. Its industrial slump has made it the worst performing of all the major European economies. Government spending and borrowing is soaring as it starts to rebuild its military in the face of Russian aggression, and its political system is trapped in permanent coalitions that makes significant reforms impossible, while the far-right AFD rises in the polls. Germany is not in as much of a mess as France, but it is hard to see Frankfurt becoming a major financial centre any time soon, even if it is home to the European Central Bank.

Both cities have blown the opportunity. In the end, both were too bogged down in domestic politics and their own economic decline, while the EU carried on imposing more and more regulations on finance, ignoring the opportunity to deregulate. It has been a long time since we read a report about bankers relocating to Paris or Frankfurt, and we certainly won’t be hearing about many over the next few years.

The UK is hardly in great shape. London has plenty of challenges if it is to survive as a major global financial centre. It needs to find a way of reviving the IPO market to reverse the decline in the equity market, to stem the exodus of entrepreneurs, to persuade the government to stop raising taxes all the time and to embrace new technologies to stay ahead of its rivals. And yet, it does have one thing going for it. Despite leaving the EU, it has won the battle to remain Europe’s main finance hub. JPMorgan’s new tower will prove it.

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Donald Trump’s attempt to hammer out a truce between Russia and Ukraine remains in the balance, but defence shares are already slipping at the prospect of the three years of bitter fighting finally coming to an end. It is not hard to understand why. Defence has been one of the few stars in a generally dismal European economy, with shares soaring on expectations that governments across the continent would spend a lot of money in the years ahead on rebuilding their armed forces.

The big German defence contractors were the stand-out performers on the back of the huge increases in borrowing and spending, much of it directed to the military. Rheinmetall shares were up 170% over the last year, before the latest sell off. Yet with the European Union also planning a €150 billion common defence fund, all the continent’s major companies were expected to get a lot of lucrative contracts. So Italy’s Leonardo had doubled, while France’s Thales was up by more than 70%. Even environmental, social and governance (ESG) funds were starting to invest in the sector.

A ceasefire in Ukraine could change all of that very quickly. Trump is pushing hard for a deal and it will prove hard for Ukraine to hold out against that. The war has reached what looks like a stalemate, with huge losses on both sides. Sure, it would be better if Ukraine could achieve a victory and Vladimir Putin were removed from power in Russia. But there does not seem to be much chance of that happening. An end to fighting would save a lot of lives and might be the best option available. And so investors are right to reassess.

If there is a peace deal, governments across Western Europe may very quickly go back to spending more money on welfare, or trying to bring their deficits under control and keep the bond markets happy. If there is no security emergency on their doorsteps, it will be hard to persuade voters to keep spending money on defence that could be spent on healthcare, social security or infrastructure instead. That is what they did after the Cold War ended, and it is very easy to think that the same thing will happen again. If it does, the defence giants may find their order books starting to dry up very quickly.

Peace in Ukraine would not end the need to rearm

Even so, there are two reasons why this is not the most likely outcome. To start with, any peace deal will almost certainly include some security guarantees for Ukraine. It is not likely to be allowed to join Nato, but there may well be a peacekeeping force that is drawn from Europe, as well as help for restoring its own armed forces so it can defend itself from further attacks. All of that will mean that money has to be spent on kit for the soldiers who will be keeping an eye on the new border between Russia and its neighbour.

Next, and more importantly, if the Ukraine war is settled, at least for now, then the US will inevitably accelerate its withdrawal from Europe. This had already started under previous presidents, but Trump has made it very clear that the US does not intend carry on paying for the defence of the continent. Trump wants all the major countries to commit to spending 3% or more of their GDP on their armed forces, while the US turns its attention elsewhere. The war in Ukraine has kept America engaged in Europe for the past three years, but without that emergency, it will focus instead on the far larger contest with China for the dominant role in the Pacific. The result? Europe will have to carry on paying much more for its own defence. It won’t have any other choice. Russia will remain a hostile, threatening opponent, and with less support from America, Europe will have to remain in a high state of alert.

European governments, including of course the UK, might want to cut spending – there will be plenty of demand for more spending elsewhere. If the peace holds between Russia and Ukraine, it will be very tempting to make savings. But in reality, that won’t be possible. Military spending will have to keep rising – and that means the boom in defence shares will carry on for many more years to come.

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What’s going on in Germany?

The nation has a newish leader, elected on a wave of muted enthusiasm – or at least a sense that he couldn’t be as bad as the last lot – but who has quickly proved a disappointment in office. His government is looking weaker by the day, and he seems unable to tackle the deep-seated economic problems the country is facing. So yes, that’s Keir Starmer, of the British centre-left. It’s also Friedrich Merz, of the German centre-right. After just six months in power, Merz’s coalition is beset by infighting, policy deadlock and sliding poll ratings. His CDU/CSU bloc (the coalition’s biggest party) hasn’t slumped as dramatically as Labour. But its support has fallen to 25%, a historic low for the nation’s dominant party of government, and it’s now polling behind the far-right AfD. Six months in, fewer than one in five Germans wish to see Merz stand again next time. “There has never been such widespread dissatisfaction with a government in such a short period of time,” says Forsa pollster Manfred Gullner.

Why all the gloom?

Largely, it’s a growing realisation that the government will not be strong enough to tackle Germany’s fundamental economic and fiscal problems. Growth in GDP has been all but flat for three years and there was initial optimism that the Merz government might give it the kick-start it needs. In the spring, Merz (as chancellor-elect) used the outgoing Bundestag to negotiate and push through a historic package of fiscal reforms that partially untethered Germany from its self-imposed constitutional “debt brake”. The brake limits public borrowing to 0.35% of GDP in any given year, but it has now been lifted for infrastructure and defence spending (but not other areas). His government embraced a kind of Keynesianism, creating a €500 billion infrastructure and climate fund, and announced much higher defence spending. There were hopes that this bold stroke might stimulate growth and presage further reform. There are, however, big problems.

What problems is Friedrich Merz's government facing?

Political weakness. It looks increasingly likely that Merz, who turned 70 this month, may well have pushed through his most consequential reform before he even became chancellor. In that outgoing Bundestag, Germany’s centrist parties still had the two-thirds majority needed to amend the constitution. By contrast, Merz’s coalition has a very slim majority, making similarly radical constitutional change highly unlikely. Meanwhile, that coalition is already publicly fracturing on traditional left-right lines. For example, Merz (a fiscal hawk by instinct, despite his debt brake) warns that the country has been “living beyond its means” for years, and the finance ministry has warned of a €172 billion hole in its spending plans for the rest of the decade. Merz is trying to lay the ground for major reforms to pensions and the wider welfare state, which account for 31% of GDP, one of the highest levels in Europe. But Barbel Bas, his SPD (social democrat) labour and social affairs minister, publicly dismissed the chancellor’s recent big speech on the subject as “bullsh*t”. It doesn’t augur well.

What are the other problems?

There are big question marks over whether the spending reforms already passed will drive robust growth. Defence spending is unlikely to do much in the long-term. Infrastructure spending has a greater multiplier effect, but the €500 billion package is not as big as it sounds: it’s spread out over 12 years, and the German press reports that some of the funding earmarked for infrastructure is in fact being diverted to cover day-to-day spending. There is scepticism about the state’s capacity to deploy money swiftly or direct it towards productivity-enhancing projects. Merz’s “autumn of reforms” has also disappointed, consisting of tinkering around the edges of welfare benefits.

What’s the bigger picture for the German economy?

That the economy has been stagnant for the whole of this decade. The country has been battered by geopolitical headwinds: Russia’s war in Ukraine and the energy-price spike, aggressive Chinese competition in traditional German manufacturing sectors – including cars, where China dominates in electric vehicles – and Donald Trump’s trade wars. All these have helped undermine the export-led model that underpinned Germany’s prosperity; manufacturing still accounts for one-fifth of the country’s gross value added. Industrial production is no higher than it was in 2005 and “many of Germany’s economic core strengths have turned into vulnerabilities”, says Marcus Berret of Munich-based consultants Roland Berger. Those include a “large industrial base that is hard to decarbonise, a high dependence on exports at a time when globalisation is under threat, and a mighty vehicle industry having to write off 140 years of internal combustion-engine expertise”. Meanwhile, Germany’s technology and digital sectors remain underwhelming. But the government, like its predecessors, shows few signs of dealing with these issues.

Could Friedrich Merz get a grip?

After shrinking for the past two years, most analysts expect growth to be a miserly 0.2% this year. Stronger growth is forecast in 2026, but projections have become more pessimistic. Last week, Merz’s own team of advisers downgraded their forecast for 2026 growth to below 1%. Businesses’ confidence has slumped and unemployment is rising (to almost three million, its highest rate in 14 years). A couple of years ago, The Economist ruffled feathers in Berlin by dubbing Germany the new “sick man of Europe”, arguing that for years Germany’s outperformance in old industries papered over its lack of investment in new ones. An obsession with fiscal prudence led to too little public investment and investment in digital technologies as a share of GDP is woefully low; less than half that in the US or France. Germany’s reliance on imported energy (70% of the total) and its ageing population make it ill-equipped for the future. Is Merz the man to turn all this round? On the evidence of his first six months, it seems very unlikely.

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It was possibly the worst news the industry could have received. Last week, the EU set out plans to cut the amount of steel it allows to be imported into member countries by half and impose tariffs of 50% on top of anything above that. With US president Donald Trump imposing steep levies on imports into the US, the EU is worried that manufacturers will start dumping excess production in Europe instead. It may well have a point. After all, there are not many other places it can go, and production can’t be wound down very quickly. Almost 300,000 people still work in Europe’s steel industry, with an estimated 2.5 million jobs dependent on its supply chain, and it can hardly afford to give those up. Tariffs are an obvious response.

That will hit British manufacturers harder than anyone. The EU is the largest market for steel made in the UK, with exports worth £3 billion a year. And it was not as if the industry was in great shape to begin with. Even with the trade deal that was agreed with Trump over the summer, the industry is still likely to face tariffs in the US after the government failed to reach a deal to exempt it. And it has been struggling with the highest industrial electricity prices in the developed world. Power in the UK is now twice the price of that in France and four times the price in the US. Given that energy can account for up to 40% of the costs of a steel plant, that has made British producers hopelessly uncompetitive on global markets. Add in higher wage costs, land prices and taxes, and it is very hard for most plants to compete. An extra 50% tariff in the EU will surely make it impossible. Exports will inevitably dwindle away to nothing.

It’s net zero or British steel, not both

Over the next few weeks, we can expect ministers to scramble around looking for a solution. They may offer big concessions to the EU to avoid the tariffs, such as conceding a youth mobility scheme. But that will just create problems elsewhere. British university and school leavers are already facing a huge shortage of jobs and it is hard to see how more competition from the EU will help that; or it could offer yet another round of subsidies and state aid. Almost half of steel production is now effectively controlled by the state. But the government is already strapped for cash and hardly in a position to offer open-ended subsidies to the steel industry.

Right now, the government is stumbling towards a half-hearted nationalisation. It has already taken control of British Steel, with a plant in Scunthorpe, earlier this year, while Liberty Steel, with plants in Rotherham and Stocksbridge, collapsed into government control last month. The plan, apparently, is to keep them alive while the government looks for a buyer, but there don’t seem to be any takers, and the tariffs from the EU make it unlikely any will emerge now. Half the industry has already been effectively nationalised, and the other half may not be far behind.

It is time for the government to make a grown-up decision. The steel industry should be closed down. It has been getting less and less competitive for years. It will soon be locked out of both the US and European markets by tariffs. The domestic market is not big enough to support it by itself, and with the accelerating deindustrialisation of the economy, it is getting smaller all the time. The unions and Labour MPs will demand subsidies to keep the industry and jobs alive. That would be a huge mistake. It will prove to be a waste of money that could be better spent elsewhere. Perhaps more importantly, closing down the steel industry will force the country to face up to the fact that successive governments have destroyed the industrial base through green regulations and soaring energy costs.

That would make the UK the first major developed country without any form of capacity to manufacture steel. And that will be a huge strategic weakness. But there is no point pretending the UK can still be an industrial power while also leading the world on hitting net zero. The country will have to make a choice. The steel industry can’t stagger on in its current form and we can’t afford the subsidies. It would be better to let it fade away and focus instead on those industries that can still be saved.

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The apologists for the relentless expansion in the size and cost of Britain’s public-sector debt like to point out that other major developed economies face a similar predicament.

Although government bond yields have risen further and faster in the UK than elsewhere, they have also increased sharply in the US, Germany, France and Japan, countries with – except for Germany – higher debt relative to GDP. If Britain is on the wrong path, then it is a path endorsed by everyone else.

Where have we heard this argument before? In early 2020, the governments of nearly every developed country imposed lockdowns in an attempt to prevent the spread of Covid. Scientists advising the UK government advocated a policy of lockdown for no more than nine weeks.

However, the government found lockdowns to be popular, enjoyed the micro-management of people’s daily lives and relished the task of crisis management. Only reluctantly did it lift all restrictions at the end of 2021, having incurred vast financial costs.

This was the greatest political, financial and social disaster for more than 100 years, instilling in the population a culture of hypochondria and dependence on the state that has proved extremely difficult to shift. The benefit to the nation’s physical health was, at best, doubtful.

Only one country broke ranks and followed a very different path with no lockdowns: Sweden. So, perhaps Sweden, rather than the US, Japan and the rest of Europe, can teach us how to manage our economy?

In the 1980s, leftists saw Sweden as a socialist utopia for its all-embracing welfare state, stringent regulation and high taxes. Moreover, the country remained a democracy, although the same party, the Social Democrats, had been in power almost continuously for 50 years. Why couldn’t Britain follow the Swedish example?

How Sweden turned its economy around

While Britain’s national debt-to-GDP ratio has risen from 79% to 96% in the last ten years, Sweden’s has declined from 46% to 34%. Swedish ten-year government bonds yield 2.5%, compared with 4.7% in Britain, so its debt-servicing costs are a fraction of the UK’s. Sweden certainly benefited from having largely avoided the extravagance of lockdown spending, but the UK’s debt ratio had been rising steadily since 2000, from 28% to 77%.

The gulf in yields and debt loads has come about because Sweden suffered an economic crisis in the early 1990s and made a radical change of course. With a fiscal deficit of 11% of GDP in 1993, a debt-to-GDP ratio of 90% and the economy in deep recession, the Social Democratic government made deep cuts to public spending.

Fiscal retrenchment was 8% of GDP over four years, two-thirds from spending cuts, notably to benefits, and one-third from tax increases. The currency was devalued, interest rates fell, and economic growth returned. Mass privatisations followed.

The economy ground to a halt in 2023, but real growth in GDP per capita has averaged more than 1% for the last ten years, compared with 0.75% and slowing for the UK. Swedish inflation is a little over 1%, the UK’s is nearly 4%.

Sweden’s tax-to-GDP ratio, according to the OECD, is high at 41%, but the government has just announced $3 billion of tax cuts, bringing it down. Adjusted for population, this is equivalent to nearly £15 billion in the UK. The UK’s tax-to-GDP ratio for 2024-2025 is estimated at 39%, but with UK public spending accounting for 45% of GDP, the UK’s tax take will inevitably leapfrog Sweden’s.

VAT, at 25%, is higher than in the UK, but since 2005 there has been no inheritance tax, and since 2007, no wealth tax. Moreover, “the Swedish welfare system is based on the general principle that everyone contributes and everyone gets equal access”. The tax system is progressive, but does not try to load the burden as heavily as the UK on “those with the broadest shoulders”.

The Swedish stock market is in rude health. In the ten years to March 2024, 501 companies listed in Sweden, more than the number in France, Germany, the Netherlands and Spain combined and lagging only the UK at 765.

Since then, there have been more flotations in Sweden than in the UK, although Klarna, the $50 billion Swedish fintech company, chose to float in New York rather than Stockholm this month. The number of listed companies has fallen by a third in ten years.

About 40% of the Swedish stock market is owned by domestic pension funds, while 25% of adult Swedes invest directly; 70% own mutual funds. The equity market has doubled in the last ten years, while the UK’s All-Share index is up 50%. No British leftist advocates following the Swedish example nowadays.

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It’s difficult to imagine a time when anybody was more bullish on Europe than America, but this was a popular investment thesis before the global financial crisis. The US had a giant housing bubble, a vast trade deficit and a currency in steady decline. Consumers were heavily dependent on spending their savings, according to statistics at the time (this data later got revised, and those eight quarters with a negative savings rate turned out to be an error – a good example of how unreliable statistics can be, as I discussed last week). Europe also had housing bubbles, but otherwise looked sounder and was well placed to benefit from emerging market growth.

We all know how this theory turned out. Europe has trailed the US on virtually every financial measure since the crisis (one can very fairly argue that Europe still offers a better quality of life in many ways, but that’s not what we are looking at). The reasons for this go beyond the idea that America is simply more innovative and dynamic, with a whole series of events working against Europe or for the US.

The eurozone debt crisis dragged on far too long, with far too much can-kicking. The shale revolution created a huge advantage for US growth and for the trade balance. Regardless of one’s views on Brexit itself, most people would acknowledge that the process was a distracting, exhausting upheaval for both Britain and the EU. Most recently, Russia’s invasion of Ukraine turned an energy disadvantage into a crisis, put a full-scale war on the borders of a continent that was complacent and completely unprepared for it, and sent uncertainty and fear rocketing. Look back at all this and maybe we should be amazed that Europe hasn’t done even worse.

Still, it didn’t help that Europe put its head in the sand much more than America when cleaning up its banks after the crisis. US policymakers did not exactly get this right – banks were bailed out too freely, there was no accountability for the actions that led to the crisis, and interest rates were cut too low and stayed there too long. Yet its bank stress tests were a success: they led to clear recapitalisation plans, restored confidence in the sector and left banks able to lend again.

European banks stocks are accelerating

Europe’s stress tests were a fudge, and markets knew it. Banks were not recapitalised quickly: they only gradually recognised bad debts while they rebuilt capital. Ultra-low interest rates hurt profitability and made this process slow. That meant that they were in a weak position to lend, even if demand was there. So, US bank shares far outstripped European ones for the next decade.

Yet on the eve of the pandemic, European banks were finally in better shape. After shares bottomed in April 2020, they began to rally. Since 2023, they have beaten US banks and are accelerating. Valuations are rising: the Euro Stoxx Banks index is on a price/book of 1.1, up from 0.7 two years ago. Banks are highly cyclical, and I never like the sector, but they are central to the economy. If Europe is to regain ground against the US this decade, they should have further to run over the long term.

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When Donald Trump began unveiling his tariff plans in April, investors feared we were entering a sharp and sudden bear market. Stocks dropped sharply around the world, with the US down 10% in two days. Yet the plunge was short-lived: stocks rallied as abruptly as they had dropped. The US and other major global markets have gone on to new highs. So did investors get rattled too easily – or are they too sanguine now?

On the optimistic side, the deals that the US is striking with trading partners look less damaging than everybody feared in April. Yes, tariffs are unwelcome. They bring complexity and friction to global trade and add costs. Those costs will be borne to varying extents by the entire supply chain between foreign exporters and US consumers. Yet these deals still reduce the risks of a wider and more damaging trade war.

The pessimistic take is that America’s views on the rest of the world have changed. It is backing away from principles that it has championed for decades to become insular and mercantilist. Policymaking is more arbitrary and unpredictable. We can’t even be confident that these deals – which are still broad frameworks – will be honoured, let alone what might come in the next three-and-a-half years and beyond.

US stocks vs the world

So the rest of the world is reacting in a rational way. Countries are striking deals with the US to minimise immediate disruption, but over the longer term they will have to recognise that the world is changing. Trade patterns and alliances will shift. CEOs are also trying to flatter Trump by announcing large investments in the US to avoid being targeted – we are seeing plenty of this from pharma firms in an effort to ward off threats of high tariffs on imported drugs. Yet it remains to be seen how much will be puffing up investment that was already in the pipeline and how much actually materialises.

We will be looking at how all this could play out at Turmoil, Tariffs and Trump 2.0, our next annual MoneyWeek Wealth Summit on 7 November (tickets have just gone on sale at moneyweekwealthsummit.co.uk/2025). However, in stock market terms, there is one obvious idea for managing these risks.

US stocks have so far outstripped the rest of the world over the past 15 years that they now make up 60%-70% of the global market, depending on which index you track. This has been driven by superior earnings growth, but valuations have also diverged much more than many investors realise.

The MSCI USA trades on 23 times forecast earnings, while the MSCI Europe is on 14. Look back to mid 2016 – about the time the divergence accelerated – and the MSCI USA was on 17 times forward earnings, while the MSCI Europe was on 15 times. So striking a better balance between the US and the rest of the world than a typical global tracker fund doesn’t need to be a bet on whether Trump’s policies will ultimately hurt the US. Doing so is increasingly justified by the growing gulf in valuations.

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“It will make Europe a leader in this market,” boasted Ursula von der Leyen, the president of the European Commission, when the Chips Act was passed back in 2023. The Commission was to mobilise €43 billion in public and private investment in microchips to make the continent a world leader in technology. It would pump money into research, development and state-of-the-art technology.

At the time, there was a global shortage of processors, and the US under Joe Biden was pursuing an even more ambitious strategy of self-sufficiency in chipmaking. It seemed vital Europe followed that lead. The target was 20% of the global market by 2030, double the percentage when the programme was announced.

How is it coming along? Intel announced last week that it was giving up on Europe. The giant chipmaker said it was scrapping planned investments in Germany and Poland. That was one of the cornerstones of the entire strategy, with a planned €30 billion chip manufacturing complex in the German city of Magdeburg and a related €5 billion plant in Wroclaw, Poland. Both were promised massive subsidies by national governments and were scheduled to go live in 2027.

Instead, Intel will be moving production to Vietnam and Costa Rica. Meanwhile, Tesla is going to South Korea to start making the chips it needs for its operations. Nvidia, which relied on Taiwan’s TSMC for its supplies, has started working on an American factory, but so far, there is no sign of one in Europe. As for new start-ups, there is absolutely no sign of them.

Why the Chips Act failed

In short, the Chips Act has been yet another epic failure of state planning. There were three big problems. To start with, it focused far too much on raw production instead of quality. The really generous subsidies were for plants such as the one planned by Intel that were planning to churn out very basic chips to go into cars and TV sets and dozens of other devices. That is a commodity industry and brutally competitive, where Europe’s high labour costs were always going to count against it.

Next, even when new factories did get the go-ahead, they quickly became entangled in red tape, making it impossible to get them operating on time and on budget. There is no point offering subsidies to chipmakers if you don’t also strip away the legislation that undermines their competitiveness. Worse, the one-sided trade deal the EU has signed with Donald Trump is likely to mean Europe will have to allow US chips into the European market, but that any processors made on this side of the Atlantic will face 15% US import tariffs.

Can the European Chips Act 2.0 succeed?

Finally, as bureaucrats often do, they misjudged the cycle. It was clear in 2023 that far too much money was being spent on chip manufacturing. Biden had pledged $230 billion for his Chips Act, and Japan, Taiwan and South Korea, which already had the real expertise, were stepping up their investments as well. Indeed, even as the investments were announced, giants such as Samsung were warning that falling chip sales were hitting profits. It should have been clear that as new factories came on stream, there would be a glut of chips. But the pen-pushers in charge of the programme know so little about how markets work that they failed to notice.

Incredibly, the EU is now planning a Chips Act 2.0, even though the first one has achieved nothing. Instead of hitting 20% of the global market by the 2030s, it looks more likely that Europe’s share will drop to 5%, and perhaps even less. There is a bigger point here. Governments around the world have been obsessed with industrial strategies and picking winners. But the outcome is always the same.

Lots of money is wasted and very little achieved. If governments genuinely want to compete in high-tech industries, the formula is simple. Forget about industrial strategies, partnerships with a handful of giant corporations and trying to pick the technologies of the next decade. Instead, focus on encouraging entrepreneurship, reducing regulation, especially for start-ups, and removing the barriers to growth.

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How has defence spending increased globally?

Total military spending by nation states reached $2.72 trillion in 2024, a rise of 9.4% in real terms on the year before, according to the Stockholm International Peace Research Institute. That’s the tenth consecutive year of increases, and the steepest year-on-year rise since at least 1988 – and takes spending on defence to about 2.5% of global GDP. The world’s biggest spenders are the US, China, Russia, Germany and India; together, these five account for about 60% of the total. Last year, spending increased in every region of the world – with especially strong growth in Europe and the Middle East – as geopolitical tensions grew. Average military spending as a proportion of overall government expenditure rose to 7.1%, while world military spending per person was the highest since 1990, at $334.

Which countries saw big jumps in defence spending?

Israel’s spending surged 65% to $46.5 billion – the steepest annual rise since the Six-Day War of 1967 – taking its total to 8.8% of GDP, the second highest in the world (after Ukraine’s 34%). Lebanon’s spending rose by 58% to $635 million; Iran’s fell 10% in real terms. The Middle East’s biggest spender is Saudi Arabia, with an estimated $80.3 billion. But it saw a modest rise of 1.5% and real spending is 20% lower than a decade ago, when the country’s oil revenues peaked. The biggest jump in spending in Asia was in Myanmar, where it rose 66% to an estimated $5 billion. Japan’s outlay is up 21% to $55.3 billion in 2024, the largest annual rise since 1952. Mexico’s spending rose by 39% to $16.7 billion, as part of the government’s militarised response to organised crime. In Europe, Sweden increased its spending by 34% to $12 billion (2% of GDP) in its first year of Nato membership – a direct response to the increased threat from Russia.

What about the rest of Nato?

Germany’s expenditure rose by 28% to reach $88.5 billion, making it the biggest spender in Europe (not counting Russia, where spending grew 38% to an estimated $149 billion – twice the level of 2015 and 7.1% of GDP). Poland’s spending grew by 31% to $38.0 billion in 2024, or 4.2% of GDP. Total spending by Nato members totalled $1,506 billion ($1.5 trillion), or 55% of the global spend. Easily the world’s biggest spender remains the US, where the total rose 5.7% to $997 billion – that’s 66% of the Nato total, and 37% of the world’s. China, the second-biggest spender, upped spending by 7% to a $314 billion, marking three decades of consecutive growth.

What about defence spending in the UK?

It raised defence spending by 2.8% to reach $81.8 billion, making it the sixth biggest spender worldwide (France, with $64.7 billion, is ninth). The UK currently spends 2.3% of GDP on defence, but last month – under intense pressure from the US – joined the rest of Nato (except Spain) in promising to raise spending to 3.5% of GDP by 2035, and 5% once further security-related spending is taken into account. If they achieve that target, Nato members will be spending $800 billion more every year, in real terms, than they did before Russia invaded Ukraine.

Will defence spending drive economic growth?

That’s what politicians are telling voters. Keir Starmer says defence will offer “the next generation of good, secure, well-paid jobs”. The European Commission says it will bring “benefits for all countries”. In reality, such hopes are likely to prove forlorn, says The Economist. Rather, the “most obvious economic consequence of bigger defence budgets will be to strain public finances”, meaning higher deficits and probably higher interest rates – none of which will aid growth.

Historically, military spending is “not a major growth booster”, agrees Pierre Briançon on Breakingviews. A recent paper by the Kiel Institute for the World Economy found the “fiscal multiplier” is often lower than one – meaning that a rise of 1% of GDP in military spending triggers an overall rise in GDP of less than 1% in the short term. Similar analysis by Goldman Sachs estimates that the multiplier in Europe is even lower, at 0.5, meaning that for every extra €100 spent on defence, the region’s GDP rises by just €50.

So defence spending is nothing to get excited about?

Any long-term economic effects will depend on where the extra money comes from and how it is spent. According to Ethan Ilzetzki, professor at the London School of Economics and the author of the Kiel Institute report, any growth boost will be greater if governments choose to fund it through borrowing instead of higher taxes, which would have a negative impact on growth. This will be much easier for low-debt Germany than for higher-debt Britain and France. Moreover, simply setting targets risks wasteful spending on low-value projects. For the economic impact to be significant, it is crucial to focus the spending on research and development, given that “publicly funded innovation often has the effect of spurring private innovation”, says The Economist. Currently, for the EU, expenditure on research and development is a paltry 4.5% of defence spending, compared with 16% in the US.

What else will help?

Greater pan-European co-operation and integration – importantly, including the UK – and a shift away from buying American. Europe’s most pressing need is to create its own “strategic enablers” independently from the US, says Hugo Dixon, also on Breakingviews. That’s military-speak for projects such as satellite-based intelligence, air-defence shields, and a joint command and control system. Such things are expensive and technologically complex, and it makes sense to create them collectively. To get the biggest bang for their buck – militarily and economically – Europe needs to favour its domestic industry. Imports currently account for more than 80% of Europe’s defence procurement, of which three-quarters comes from the US. “To manufacture more weapons at home, national capitals would have to agree common strategic needs, pool resources and keep restructuring the defence sector.”

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War fever appears to have gripped Britain’s media. Never able to resist an opportunity to catastrophise, pundits are now predicting at best a return to the Cold War, at worst a full-scale invasion of Europe by Russia as it seeks to recreate the geopolitics of the old Soviet Union.

This follows America’s U-turn over its previous support for Ukraine and the long-threatened withdrawal of its defensive shield for Europe. Europe now realises America means it and is therefore in a rush to rearm lest a victory in Ukraine is followed by an onslaught against Eastern Europe. Why, the media wonders, are financial markets ignoring this, with UK and European stock market indices regularly hitting new highs?

The reason is that the collective wisdom of markets is far greater than that of the armchair generals paid to prey on everyone’s worst fears. Russia is a paper tiger and while it is indisputable that Europe needs to beef up its defences, this does not mean that it has to prepare for an inevitable war. It is because Russia is a paper tiger that America can withdraw its forces; Europe is eminently capable of defending itself.

Russia's deeply unpopular campaign

Russia has the largest population in Europe, comprising 145 million people, but this total is far below the 250 million of the former Soviet Union, to which could be added the 150 million in Eastern Europe that have now switched sides.

A million Russians of fighting age have left the country and it’s a safe bet that those who remain are unenthusiastic about joining up, especially as another million have been killed or wounded in the Ukraine. Russia has been able to pull in troops from North Korea and some volunteers from Central Asia, but these people are likely to be even less enthusiastic.

The population of Europe, excluding Russia, exceeds 550 million and is far more prosperous. Russian GDP per capita of $14,000 is less than a third of the UK’s and about a quarter of Germany’s.

In fact, few European countries are poorer than Russia – Serbia, Albania, and North Macedonia are among them. The Russian economy is struggling to sustain its invasion of Ukraine and is in no position to take on Europe in terms of technology, industry and finance.

Russia has a border with Estonia and Latvia, but not with Poland or Lithuania, other than from its enclave of Kaliningrad, formerly part of East Prussia. It could not amass an invasion force there without its intentions becoming blindingly obvious.

Belarus, between Russia and Poland, is allied to Russia, but has not joined in the war on Ukraine nor allowed its territory to be used by the Russians. With a population of just over nine million and a GDP per capita barely half of Russia’s, Russia could easily swallow it up, thereby giving Europe ample warning of its intentions.

Europe can easily afford to spend a lot more on defence. If this came from the welfare budget rather than from taxes or borrowing, it might even be an economic benefit. Its technology is far superior to Russia’s and technological advantage, rather than manpower, wins wars. But surely Russia’s nuclear weapons are a trump card?

More probably, they pose an empty threat: unreliable, slow and obsolete, easily shot down by defensive systems, unlike the nuclear weapons Britain, France and America have at their disposal. Russia has not dared to use nuclear weapons against Ukraine, which supposedly doesn’t have them. However, Ukraine has missile technology, drone technology and nuclear power, so it should not be difficult for it to build nuclear weapons, if it has not already done so.

The war against Ukraine is very far from over and any assumption that Russia will gain the upper hand is premature. The British army in World War I has been described by some historians as “lions led by donkeys”, but the Russian army has shown itself to be staffed by donkeys led by donkeys.

With a military breakthrough out of sight, the fear is that Russia would use any truce to rearm and refill the ranks of its army for another go. But if Ukraine could put nuclear warheads on its long-range missiles, that could be even more disastrous for Russia than its current invasion.

The share price of JPMorgan’s EMEA Securities Trust, formerly JPMorgan Russian Securities, trades at five times its net asset value (NAV), having nearly trebled in the last six months. Its Russian investments were written down to zero three years ago, but investors clearly believe that value will return. What do they think they know? Probably more than the armchair pundits.

This is not like the summer of 1914 with markets oblivious until the last moment of the growing threat of world war. Markets face many threats, but a Russian invasion of Europe is not one of them.

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There’s been plenty of “political mudslinging” since France’s Marine Le Pen was found guilty of embezzlement and sentenced to an immediate five-year ban from running for public office, says Victor Goury-Laffont in Politico. Hungary’s Viktor Orban, Italy’s Giorgia Meloni, the Kremlin, Donald Trump and Elon Musk have “all weighed in”.

Many have criticised the verdict as an “anti-democratic attempt” to bar an opposition candidate – and the current front-runner – from competing for the French presidency in 2027.

On the other side of the debate, the verdict has been hailed as justified because Le Pen has been found guilty of embezzling EU money to fund her party over 11 years, says Bruno Waterfield in The Times. As Rémy Heitz, one of France’s two top judges, told RTL, this was a judicial decision, “handed down by three independent, impartial judges”.

Since the verdict, Le Pen’s tone has risen to “histrionic heights”, says Anne-Elisabeth Moutet in The Telegraph. At one point she even compared herself to the late Alexei Navalny, the opponent of Vladimir Putin. While she and her 12 former assistants are “undeniably guilty” of using money (€4.4 million) from the European Parliament to “finance National Rally aides”, she may have a right to feel singled out.

Albeit on a smaller scale, members of both Francois Bayrou’s centrist party and Jean-Luc Melenchon’s hard-left party have got into hot water for allegedly using parliamentary assistants for partisan purposes.

The main target of her “outrage”, however, is the Sapin Bill, which president François Hollande tightened in 2016 to ensure that “any politician condemned for corruption would be barred from running for office even if they appealed”. Top legal experts have said that it “contradicts the spirit of judicial independence”.

Marine LePen may be down but she is far from out

It’s possible that the constitutional council could be asked to look into whether the verdict “somehow contravenes the French constitution”, says Henry Samuel in The Telegraph. However, Le Pen’s main hope of running in the 2027 presidential election is if the decision is reversed by appeal before then.

There is no way to challenge the immediate ban, but the Paris Court of Appeals threw Le Pen a “potential lifeline” on Tuesday by saying it aimed to decide the appeal in the summer of 2026, giving her plenty of time to prepare for an election, says Leila Abboud in the Financial Times.

The third option is for Emmanuel Macron to grant her a presidential pardon, says Samuel. Since he has limited himself to commenting, “The law is the same for everyone”, this seems unlikely.

For now, Le Pen will not “disappear from the political stage”, says Abboud. She can still continue as a member of France’s National Assembly, in which her party is the largest single opposition grouping, with 123 MPs. During her political career, which spans nearly 30 years, she has worked to “detoxify” the party’s racist image and win over working-class and rural as well as older, wealthier voters, steadily increasing its vote share to roughly one third.

The party’s young, charismatic president and likely Le Pen successor, Jordan Bardella, has announced demonstrations across France this weekend and started a petition, which has attracted so many signatures that the platform has crashed, says Waterfield.

If a narrative takes hold that France’s “democratic destiny” has been “confiscated” by a “judicial cabal”, it will reinforce the National Rally argument that the political system is “rigged against them after the party was locked out of power by tactical voting in the parliamentary elections last year”. This verdict could “mobilise” the party’s base and “shore up support” as it heads into an election campaign in 2027.

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Germany’s chancellor-in-waiting, Friedrich Merz, is under fire from opposition politicians over his “radical proposals” to relax the so-called debt brake to boost the economy and allow for higher defence spending, says Kate Connolly in The Guardian. The CDU/CSU leader’s proposals, agreed with his potential coalition partners, the Social Democrats, have variously been described as a “bazooka” and an “extremely risky bet”. Merz says they are vital “in light of the threats to our freedom and peace”.

Merz, who is in coalition talks to form a new government, which are expected to run until 24 March, wants to get his plans through the current parliament, where the conservatives and SPD have the necessary two-thirds majority together with the Greens. The far-right AfD, which will have 152 seats in the new parliament, is opposed and has already said it will challenge the decision in court. “A number of other parties have political incentives to push the vote to the brink,” says Deutsche Bank Research. It’s “far from a done deal”.

What does it mean for Germany's economy?

If Merz does succeed, it would be a “big step forward” – for Germany, Europe and the world, says Bloomberg. Introduced by former CDU leader Angela Merkel in 2009, the debt brake was “much more than a mere budget rule”. It reflected Germans’ “deep-seated aversion to borrowing and to the burden-sharing required for a viable European Union”. It has also proved to be “economically disastrous, gutting the kind of productive investment desperately needed to restart growth” in the face of higher energy prices and Chinese competition. The “geopolitical chaos” unleashed by Donald Trump has forced Germany’s hand. Faced with the withdrawal of US military support and threat of US tariffs, Merz has come up with an “ambitious fiscal agenda”. Adjustments to the debt brake will allow for much higher defence spending and another €500 billion will be dedicated to a decadal-long fund to invest in the country’s infrastructure.

Using the outgoing German parliament to lead the country into “debt bondage” disregards the will of voters and will “accelerate Germany’s economic decline”, says Joachim Nikolaus Steinhöfel in Euronews. It will expand the money supply, “drastically worsen Germany’s credit rating” and encourage other countries in the eurozone to abandon “fiscal discipline” with a knock-on effect on bond markets and interest rates. Short-term, it might stimulate growth, but private investment will be crowded out while the state’s inefficient procurement system will waste billions. Defence spending won’t grow the economy.

On the contrary, many economists would argue that Merz’s spending spree is “just what Germany needs to get itself out of its low-growth malaise”, says Jeremy Warner in The Telegraph. The bigger, long-term question is whether a rearmed Germany will galvanise the country’s “reemergence as an over-mighty, political and economic hegemon at the heart of Europe”. Re-empowering the historic enemy is “surely not” what Vladimir Putin had in mind when he sent his tanks into Ukraine. “Yet this could all too easily be the ultimate outcome.”

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Fancy a few European defence stocks? Not long ago, the answer to that from pretty much all investors would have been a very firm “no”.

Defence didn’t fit the environmental, social and governance (ESG) metrics of most fund-management firms and Europe was seen as a long-term value trap.

Why buy into low productivity countries with horrible energy policies and dodgy politics if you could buy into American exceptionalism and can’t-go-wrong technology stocks instead? That’s been the right take for some time.

But around the middle of last year things started to change – and this year the shift is obvious.

Year to date, both the Dax and Cac indices have beaten the S&P 500. The former are up 12% and 9% respectively. The MSCI All Country World index is up 7%. The S&P? Down 1.3%. The Magnificent Seven (the can’t-go-wrong ones) are down over 3%.

Compare that to a basket of European defence stocks and you can see the market momentum shift in action. They are up 26% so far in 2025. Germany’s Rheinmetall, a systems supplier to the defence industry, is up nearly 55% year to date.

European markets have been the best performers globally this year so far (with the UK a close second). That’s the first time that has happened since 2012.

Why are European markets outperforming the US?

So what on earth is going on? You could argue that the world has suddenly noticed two things. First that Europe is cheap, and second that it isn’t a value trap.

The first bit makes sense – particularly if you look at it in the context of US valuations. The US is well over 30% overvalued relative to its 15-year medians on any measure you choose to use – and 56% overvalued relative to dividend yield history, says Schroders’ Duncan Lamont.

Europe (ex UK) is a little overvalued on most measures – its forward price-earnings ratio (p/e) of 15 times is 6% greater than the 15-year median, for example. But even if you think it slightly expensive relative to its own history, it is “still very cheap versus the US”.

That means that there is room in Europe for prices to rise on valuation expansion alone (as they have been this year), something that isn’t really available to the astonishingly overpriced US.

At the same time, buybacks have been on the up since mid-2021 and company earnings forecasts don’t look too bad at all. Lamont notes that 46% of US companies are forecasting double-digit earnings growth over the next 12 months. In Europe that number is 51%.

The second – the idea that not all Europe’s woes are both structural and unfixable – is arguable.

Some things have definitely improved, says BCA Research. The banks across the eurozone look better; much corporate deleveraging is complete; and there are some policy shifts underway.

There is, for example, (finally...) rising recognition that perhaps sometimes you can have too much regulation.

Fiscal austerity also looks to be easing a little.

Take Germany. The election is out of the way and the deliberations between the centrist parties assumed to be forming a coalition have taken what Deutsche Bank call a “surprising turn” – one that “could have more significant ramifications for the fiscal outlook” than the election results initially suggested.

The idea is to ease Germany’s “debt brake” in the last few weeks of the current parliament, “with a view to unlocking future debt funding for defence spending” – something in the region of €200 billion. Real money that would be used to “accelerate the rearmament drive”.

The consequences might not be huge for the domestic defence industry in the short term (it takes a while to expand production facilities), but it would still be “good news for growth in the medium term” and would “signal to the corporate sector a strong resolve to address Germany’s structural challenges”.

What does this mean for the US?

The other way to look at this shift in momentum is not in terms of excitement about Europe but of caution on the US – a sense perhaps of peak exceptionalism.

Might it be that, after an extraordinary decade, one in which the US market was the top global performer in all but two years (2017 and 2022), it is getting dangerous to be quite as exposed as most are to the US?

Perhaps China’s surprise advance in AI represented by DeepSeek has been a reminder to investors that exceptional stuff can happen outside the US too – and one that is making them slowly re-evaluate the wisdom of their lack of diversification.

Either way, US investors in particular have been allocating more and more to European and UK stocks. US investors now own 30% of the UK’s market. That’s up from 19% in 2008. They also hold 29% of Switzerland and 18% of France.

There is an argument that the US market will be protected by some kind of “Trump put” – as Bank of America strategist Michael Hartnett told Bloomberg, “the stockmarket is his traffic light”, so if it falls too much he will intervene fiscally. But US investing guru Jeremy Grantham still expects a major correction in the overvalued US market (timing uncertain!), yet has “no argument”, he tells me on the Merryn Talks Money podcast, with the non-US markets, which are “much less dangerous to own”.

If history follows the usual pattern, they will be “sympathetic” in a major decline in the US market and may drop frighteningly when it happens. But they will regroup faster, “and they will very likely over five or ten years crush the US”. Success in investing is as much about what you avoid as what you buy. Those who don’t want to be crushed might want to start rebalancing.

Merryn is Bloomberg UK Wealth’s editor-at-large, covering personal finance and investment; the author of the Merryn Talks Money newsletter; and host of a podcast of the same name. Sign up at Bloomberg.com.

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Three things emerged clearly from Germany’s general election, says The Economist.

First, the opposition conservative Christian Democrats (CDU), along with their Bavarian sister party, the Christian Social Union (CSU), won a definite if “underwhelming” victory with 29% of the vote.

Friedrich Merz will take over as chancellor from Olaf Scholz, whose SPD party was relegated to third place after its worst performance since 1887.

Second, the hard-right Alternative for Germany (AfD) secured its best-ever result, with 20% of the vote, roughly doubling its seats in the Bundestag.

Third, the “extraordinary turnout” of 83%; the highest figure since German reunification in 1990.

The popularity of the AfD, particularly among younger voters, is largely attributable to a desire for a “stricter approach” to immigration, fuelled by a series of lethal attacks involving foreigners, says The Times. In 2015, Angela Merkel “threw open the doors” to more than a million Syrian refugees.

What's next for Germany?

The combined vote for the CDU and AfD reveal that Germany’s “clear preference” is for a rightwing government, says The Telegraph.

Yet since Merz has ruled out a partnership with the AfD (regarded by many as a neo-fascist entity), the most likely outcome is a two-party coalition between the CDU/CSU and the SPD, a “discredited party of the left” – a return to the “grand coalition” that was in place for three of Angela Merkel’s four terms.

Geopolitical and economic realities should help expedite coalition talks. Added to immigration concerns is anxiety about security in the face of Russia’s expansionism and America’s “strategic retreat”, says The Times.

Merz wasted no time in heralding a new era in Europe, calling for the immediate strengthening of Europe’s defences to establish “real independence” from the US. Recently, he suggested that he would look to France and Britain to replace US nuclear guarantees.

For all the punchy talk, the road ahead is littered with obstacles. “Military autonomy will cost billions” and Germany’s economy is flatlining. The country is “a prime target for US tariffs and China’s dumping”.

Merz’s spending ability is severely constrained by a “debt brake” that limits federal borrowing to no more than 0.35% of GDP (there has been talk of scrapping this).

While the “risks of a trans-Atlantic fissure have clearly increased”, it will be hard to sever ties altogether, says Neil Shearing on Capital Economics. Despite the “head-spinning” turn of events, in practice there are “powerful forces” acting against Europe splitting from the US to become a “third superpower”.

“Political, cultural, social, economic and security ties” run “broad and deep”. Europe is an important part of the “economic diversity” of the US bloc and the US has come to rely on Europe as part of its “push to contain China”.

A deal to end the war in Ukraine might emerge more quickly. The pressure to increase defence spending will be “intense”. But the most likely outcome is that in four years’ time the US and Europe will “still be allies”.

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Is the US economy pulling ahead of Europe?

Yes. Twenty years ago, the US economy and Europe's were broadly comparable in terms of size and share of global GDP, and in 2008, the economy of the EU was in fact slightly larger when measured in current US dollars. Since the global financial crisis, however, a substantial gap has emerged. By 2024, US GDP had reached about $29.2 trillion (or around 27.5% of global GDP), while the euro area stood at about $16.4 trillion (14.7%) and the UK at $4 trillion. US outperformance is not an illusion – and has gathered pace this decade since the Covid pandemic.

What’s happening in Europe?

The boss of ABB, one of Europe's biggest engineering groups, with headquarters in Switzerland and a market capitalisation of around $200 billion, this week warned that Europe is heading towards a “mass unemployment” crisis unless politicians take urgent action aimed at boosting competitiveness. CEO Morten Wierod attacked policymakers in Brussels and national capitals for their lack of urgency in implementing the reforms recommended by Mario Draghi almost two years ago. Draghi's landmark report on European productivity and competitiveness highlighted the widening gap with the US economy. But only 10% of his 383 proposals have so far been acted upon. Other business leaders have made similar pleas in recent months.

Where does the US economy stand now?

America's outperformance began decades ago, and in the 2020s it has become “vast” and sustained, says The Economist. Recent IMF forecasts show US growth continuing to outstrip other big Western economies to 2030 and beyond. That's despite strong headwinds. Under Donald Trump, the US has become less attractive to high-skilled migrants who boost its dynamism; more vulnerable to a bond-market crisis as its debts mount and more tolerant of corruption. The Economist suggests that overall the self-harming “MAGA tax” – high tariffs, zero net migration and all-encompassing uncertainty over policy – shaved around three-quarters of a percentage point off the rise in GDP in 2025. It was closer to 2% than 3% – yet still far higher than the EU or UK.

What did the US do right?

The explanation lies in a range of natural advantages and long-run trends. The US has both continental scale and one single market and language, vast natural resources and the fiscal space that comes from issuing the world's reserve currency. While Europe's fragmented federalism holds it back, America's system means that businesses faced with unfriendly policies in one state can up sticks for another far more easily. America's shale revolution and liquefied natural-gas exports have reshaped global energy markets and driven US outperformance. Meanwhile, Europe has been hit harder by successive shocks – the financial crisis, the pandemic, the energy crisis. It struggles with its incomplete single market and remains fragmented by multiple languages, competing national interests, and different tax and legal systems.

Comparing the US and European economies

Underpinning the EU-European divergence is the growing difference between the two economies in terms of their industrial composition. The booming US technology sector has no European equivalent, and the gap is likely to widen in the age of AI. By contrast, Europe is strong in industries that have increasingly faced tough Chinese competition. The US has benefited from higher productivity, more business-friendly policies and deeper capital markets.

Is Europe really so far behind?

Economists have debated for years whether the US lead is unduly flattered by the ways in which it is measured. For example, in the mid-2000s, the US dollar was dramatically overvalued against the euro and has since fallen back, meaning that when measured in constant current dollars, the divergence appears greater than it “really” is. Others point to America's growing population and the fact that it's getting younger compared with Europe. The latest iteration of these debates is a friendly but pointed exchange of blogs and papers in recent weeks between US Nobel laureate Paul Krugman and three European economists, including the French 2025 Nobel laureate Philippe Aghion and the LSE's Luis Garciano. Krugman, drawing on recent analysis and charts by Seth Ackerman, argues that using headline GDP figures to measure the divergence is misleading and that Europe is doing better than most economists think.

Why is Europe struggling?

Broadly, Krugman's point is that when measured using GDP at purchasing power parity (PPP) – that is, correcting for domestic inflation and relative price differences – the two blocs are pretty much where they were 20 years ago (and Europe has pulled ahead when it comes to all kinds of social indicators, including life expectancy). Yes, the US dominates in rapid technological progress, but this progress is passed on to everyone in the form of lower prices and doesn't just raise US GDP. The three European economists counter that Krugman is being far too kind to Europe – and therefore unhelpful, by diminishing the need for radical reform. PPP is useful for comparing purchasing power across countries at a specific point in time, but a sequence of current-PPP comparisons does not make a credible measure of real growth.

Can Europe catch up?

The US lead in technology and innovation is “not helping America and Europe in the same way: it has led to higher US wages and profits, and the gap is widening each year”, say Aghion and his colleagues on Project Syndicate. It should not be controversial, they say, to agree that Europe is falling behind, and to obscure this reality means failing to address the causes. In short, Europe might not be so far behind as some think. But nor will it catch up unless it tackles its economic failings.

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The centrist François Bayrou, 73, has been appointed prime minister of France after a historic vote of no-confidence put an end to the “shortlived” minority coalition of Michel Barnier, says The Guardian. Barnier’s government fell after he invoked special powers to push through his 2025 austerity budget without a vote in parliament. Taking office, Bayou, a political heavyweight who helped Emmanuel Macron win the presidential election in 2017 and who has run for president three times himself, acknowledged that he had a mountain to climb. He received a “baptism of fire”, with Moody’s downgrading France’s credit rating within hours of his appointment, says CNBC. Moody’s blamed political instability for the downgrade, saying it would make it hard for France to tackle its deficit. Investors’ unease has already pushed France’s ten-year borrowing costs above 3% this year.

Bayrou, founder and leader of the MoDem party, commands respect across the political spectrum, but the National Assembly remains “crippled by the same three-bloc impasse”, says Hugh Schofield on the BBC. The opposing three blocs of the 577-seat lower house are: Marine Le Pen’s far-right party, the National Rally, Macron’s pro-business allies, and the New Popular Front, a left-wing alliance that ranges from the Socialists to the far-left France Unbowed led by Jean-Luc Melenchon. Before Bayrou draws up a new budget, he will need to form a new government, the composition of which will depend on whether he manages to build bridges. Macron has been holding talks with parties from the centre-left and centre-right to broaden the outgoing minority conservative-centrist coalition, but so far all he has got from the Socialists, who hold 66 seats, is a “vague commitment” not to vote Bayrou out immediately, says The Economist.

Will François Bayrou's government mark a shift to the left?

Macron’s obdurate refusal to appoint a prime minister from the left, despite the New Popular Front winning the most seats in last summer’s snap elections, stems from fear of having his “legacy” unpicked, says John Keiger in The Telegraph. With “tiresome predictability”, France Unbowed has already said that it will table a motion of no confidence when Bayrou’s new government is appointed. Although Le Pen is unlikely to join him this time, Bayrou will be keen to reach a truce with the Socialists and Greens in order to “rob the two opposition blocs of the majority needed to win a no-confidence vote”. In terms of the budget, the “risk of things going wrong is high”. France is deeply wedded to its “social-security provisions and generous state allowances that have cushioned the population against economic reality and left the country with an onerous tax burden”. Many still resent Macron for raising the pension age from 62 to 64, even though it is “still among the lowest in Europe”.

Bayrou’s “bridge-building instincts” are a bonus, say Leila Abboud and Ian Johnston in the Financial Times. He already enjoys reasonable relations with both sides. However, he has also been described as “having a Pyrenean-sized ego” and, according to veteran French commentator Alain Duhamel, will “not hesitate to exert his power”. He will “not be easily disciplined”, says Duhamel, and will “tilt policy more towards the left”.

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Ireland’s political landscape after 29 November's general election looked “strangely familiar”, says Fintan O’Toole in The Guardian.

Familiar, because the two main incumbent parties, Micheál Martin’s Fianna Fail and Simon Harris’s Fine Gael, received almost exactly the same combined share of the vote as they did in 2020, and will therefore continue to govern.

Strange most obviously because Irish voters have “bucked the trend” in this “global year of elections” by failing to give the incumbents a “good kicking”. But also strange, because given that Ireland is enjoying full employment, overflowing public coffers and a booming export-led economy, the endorsement was “lukewarm”. As recently as 2007, the “twins’” combined share of the vote was 70%. It is now 43%.

Their declining popularity is not, as one might expect, due to a rise in the fortunes of the main opposition party, Sinn Fein, which was, in fact, the “biggest loser”. Its vote share fell from 25% to 20%, partly because support “leached” away to right-wing candidates exploiting anti-immigrant sentiment among voters, and partly because of “internal scandals” that have made the party look “at best incompetent, and at worst cynical”.

What's next for Ireland's political landscape?

So what next? Fianna Fail and Fine Gael have a combined 86 seats, just two short of the 88 needed to secure a majority in the Dail. They could either do a deal with Labour or the Social Democrats – 11 seats each – or with the right-wing party Independent Ireland, which has four, says the BBC's Enda McClafferty.

Another option would be to turn to some of the 16 independents, but that “could mean a less stable coalition” as they would be “more likely to revolt on specific issues”, notes The Guardian’s Lisa O’Carroll. The front runner to be the next taoiseach (prime minister) is Martin, but at this stage, nothing “can be ruled out, as weeks, if not months” of political talks are on the cards.

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Europe is undergoing a crisis of creative confidence. The recent report by Mario Draghi, the former president of the European Central Bank, on Europe’s competitiveness revealed a poor innovation record. He noted that “EU companies spent around €270 billion less on research and development [R&D] than their US counterparts in 2021, largely because we have a static industrial structure dominated by the same companies and technologies as decades ago”.

His solution was to focus on more venture capital (VC) investing in high-risk projects, as a lack of VC has meant start-ups have been more reliant on bank loans, which are unsuited to financing such ventures. He noted that “the core problem in Europe is that new companies with new technologies are not rising in our economy. In fact, there is no EU company with a market capitalisation over €100 billion that has been set up from scratch in the last 50 years. All six US companies with valuations above €1 trillion have been created in that period of time. Innovative companies that want to scale up in Europe are hindered at every stage”.

What can Europe do to fix its innovation crisis?

The key phrase here is scale up. It’s all very well having lots of ideas, but if you can’t turn them into money-making global technology leviathans like the Americans, there’s a problem. Draghi’s hand-wringing has sparked schadenfreude across the English Channel. Analysts have pointed out that the UK innovation and start-up scene seems to be in much better shape. Britain is currently the third-largest venture capital market in the world, behind only the US and China; it has overtaken India to claim this position.

The UK is also the largest venture capital market in Europe, accounting for more than a third of investment, and UK companies raised £72 billion in total venture capital investment between 2021 and 2023. In 2023 alone, UK start-ups raised $21.3 billion, the third-highest total on record. Britain’s share of global VC investment rose from 3.4% to 5.8% between 2021 and 2023. London continues to be a major hub, driving 70% of total UK VC investment in the last few years.

Still, it’s not all good news. According to The Times, investment in early-stage firms has fallen to a six-year low. In the three months to September, there were 32 fundraising rounds for start-ups, the lowest number since 2018 and down from 75 in the previous quarter, according to VenturePath, a group of investors who channel capital into early-stage firms. Companies raised only £162 million in the past three months by offering shares to external investors for the first time, also the lowest figure in at least six years.

A more damning critique of the UK’s long-term record of innovation record comes in a joint report by the Tony Blair Institute (TBI) and the centre-right think tank Onward. It points the finger at the City of London: “London was once the world’s largest stock exchange and, today, it ranks sixth... Last year 76 firms delisted from the London Stock Exchange’s (LSE) growth market, Aim... up 62% on the previous year. And... leaders of the UK’s most vibrant companies have publicly stated that they would not consider listing on London’s exchanges. Low liquidity, diminished confidence among investors and a shrinking pool of capital available are compounding the exodus”.

The report went on to say that the implications are severe: not only will our failing capital markets undermine our status as a global financial hub, but they could also “extinguish Britain’s potential to be the home of the next wave of world-leading science and tech companies, hindering its growth prospects for decades”.

Propping up the market

The study’s solutions include closing down Aim and creating a rapid route to listing on the LSE’s Main Market with similar, but time-limited, tax and regulatory benefits; and expanding and enhancing the capacity of the UK’s investment sector. To that end, the UK state should earmark £1 billion of funding to invest in five growth-focused venture funds, crowding in institutional capital to create a generation of UK-based, large-scale growth investors. The report also highlights the need to cut regulatory red tape and governance burdens on asset managers and listed companies.

Those intimately involved in the complex world of funding innovation paint a more nuanced picture. Take Ken Wotton of fund manager Gresham House. His firm is uniquely positioned to understand the link between private and public-market funding of innovation-led companies. Funds range from venture capital trusts (VCTs) and enterprise investment schemes (EIS) to public market strategies for small and mid-cap stocks via the successful Strategic Equity Capital investment trust.

Wotton thinks the financial support system for innovation in the UK has been transformed over the past 15 years, with a burgeoning angel and early-stage VC sector supported by tax breaks such as EIS and VCT schemes. He accepts that the current cyclical funding environment is weak, but the solution, he argues, is not to kill off Aim.

This alternative market might not have “generated amazing returns for investors in aggregate, but has been pretty effective at raising capital for smaller businesses”. The real problem is that the dismal cyclical backdrop means that UK equity valuations are low, and thus few entrepreneurs will plump for the UK if they’ll only get poor valuations via flotations. One concrete example of where the UK outperforms is in the business-software sector, especially in software as a service, or SaaS. Yet Wotton points out that these listed tech businesses are “all trading at massive discounts to the valuations that my private colleagues are putting money into. There are many publicly quoted high-quality SaaS businesses trading at between 1.5 and three times the sales. By contrast, in private markets, you’re putting money into businesses at five times plus”.

What can Britain do?

Unsurprisingly, low valuations for the few UK tech businesses that do list quickly prompt takeover interest. However, that brings up the most acute challenge facing the UK and its innovation sector: Draghi’s point about scaling up. There are plenty of smaller-cap growth stocks in the tech sector with potential and even more that are private. But very few of them remain British for an extended period of time.

That translates to just one pure-play tech firm in the FTSE 100, Sage, which, in turn, results in the main UK equity benchmarks boasting very low exposure to tech growth sectors that global investors are keen on. It’s not that we don’t have the ideas or fast-growing businesses. It’s just that we don’t have the funding available for them to transition from being small caps to becoming global large caps. They succeed and then either go private or are taken over by larger global firms.

One industrial policy expert, Rian Whitton, argues that the British should emulate the French, who have kept hold of many major innovative businesses via a more plutocratic, family-ownership structure of global businesses. Whitton says that, “Fundamentally, wealthy French industrialists... are bigger players at home than their counterparts in Britain”. They retained control as their firms scaled up, keeping ownership in France.

A more modest proposal comes from Wotton at Gresham House. It focuses on giving incentives to business leaders, tomorrow’s Elon Musks or Mark Zuckerbergs. He says the remuneration model for listed UK businesses is a factor deterring entrepreneurs and quality managers from choosing PLC entities as opposed to US businesses or even private equity-backed concerns.

“There needs to be more tolerance of value creation equity schemes (like private equity’s sweet equity schemes) as long as [they are] aligned to long-term shareholder value creation and less reliant on the proxy agencies, such as ISS, which are black boxes on governance and not fit for purpose for scaled-up businesses.”

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It was billed in advance as a nail-biting contest, but, in the end, the result was not even close. Donald Trump won a decisive victory in the US election. That has upset some people. But there seems little doubt his restoration will boost an economy that was already doing very well to start with.

His tax cuts, for example, will be significant, even if there is a risk that they will push up a deficit that is already running at 6% of GDP. The corporate tax cut from the first term will be extended, helping the competitiveness of America’s biggest companies, and some of the battier ideas that found their way into the Democratic manifesto, such as a plan to tax unrealised capital gains, will now be scrapped.

The wild spending of the Biden years on subsidising microchip manufacturing, and building green infrastructure, will come under far closer scrutiny. There is already evidence that the $500 billion, and potentially two or three times that amount given that much of it was in open-ended tax credits, has been badly spent, and all the country will ever have to show for it will be a series of white elephants. Trump was not the great deregulator in his first term that he claimed to be, but many of the rules Biden has imposed will be repealed and the web giants will be freer from regulatory scrutiny.

The oil and gas industry, especially shale oil, which has made the US the biggest energy producer in the world, will receive a lot more support. And finally, the role of Elon Musk as an influential voice in the administration will be fascinating. Musk is almost as controversial as Trump. But there is no question he is a brilliant entrepreneur, and if anyone can work out how to cut government spending, he can. Put it all together and all this will turbocharge the economy.

Sure, there may be some mistakes along the way. The threatened tariffs of 60% on China and 10% across the board will be a disaster for the global trading system if they are put into effect, and, just as seriously, will trigger a big spike in US inflation. And unless Musk can really deliver the cuts in government spending that he talks about, the tax cuts may well send the deficit spinning out of control and trigger a bond-market revolt. Likewise, political interference in the Federal Reserve may well panic investors who hold dollars, and send the currency markets into turmoil. A lot will depend on who is appointed as treasury secretary and whether he or she can rein in some of the president’s wilder ideas.

How will Trump's policies impact Europe?

But the important point is that another spurt of rapid US growth will painfully expose the weakness of the UK, and the whole of the EU. As the recent report from Mario Draghi pointed out, the difference in real GDP between the US and Europe has widened from 17% in 2002 to 30% now. With the US growing at three times the annual rate of all the major European economies, and with productivity rising more rapidly, that is only going to widen.

The UK, with huge increases in taxes on business already crushing investment, looks as if it will fall even further behind. A relatively modest gap between the US and Europe has widened alarmingly. It now seems inevitable that the difference in GDP will rise to more than 50% over the next few years, and perhaps even higher.

This should be the wake-up call the continent needs to finally work out that its economic model has failed. It needs to find a more realistic path to net zero, given that energy costs in Europe are now twice those in the US, placing a crippling burden on what remains of manufacturing industry.

It needs to scale back welfare systems that have spiralled out of control and destroyed the incentives to work. And it needs to stop imposing more and more regulations and restrictions on business, given how few new companies it has managed to create compared with the US. Europe was already falling woefully behind the US, and that is only going to accelerate over the next four years. The only trouble is, there is very little evidence that either the UK or the rest of Europe is willing to change course.

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German chancellor Olaf Scholz has “just pulled the plug on his coalition and lost his parliamentary majority”, with polls implying that his Social Democrat party will be defeated in the snap election called for 23 February, says Guy Chazan in the Financial Times. The current government will be put to a confidence vote on 16 December, which it is expected to lose.

Despite Scholz’s low approval ratings and the wish of some in the SPD that he be replaced by the popular defence minister Boris Pistorius as SPD leader, party leaders have “rallied round” and most expect Scholz to be the name on next year’s ballot. His standing among some colleagues has “paradoxically improved” since the government’s collapse – he has been hailed as a hero who “finally lanced the boil, ending a dysfunctional government riven by ideological conflict”. Scholz fired finance minister Christian Lindner, leader of the pro-business Free Democrats (FDP), for refusing to suspend the debt brake to allow more funding for Ukraine, effectively ejecting the party from the coalition.

How does Olaf Scholz's decision impact Germany?

Donald Trump’s victory couldn’t have come at a worse time, says The Times. His plans to impose more tariffs on imported European goods are likely to be “particularly catastrophic for Germany” since America is its largest trading partner. Trump has suggested tariffs may be between 10% and 20%, possibly much higher for cars, Germany’s main export. The EU may respond in kind. The German Economic Institute estimates that a trade war could cost Germany €120 billion-€180 billion over Trump’s four-year term. Then there’s a possible Putin victory in Ukraine, “with all that this implies for the survival of the EU”, says Ambrose Evans-Pritchard in The Telegraph.

Last year, the US had a $170 billion trade deficit with the EU; Germany accounted for half of that. This “touches on a deeper problem”. The country has relied on a current-account surplus of 6%-8% of GDP for much of the past 20 years, the result of a “tax and regulatory structure, allied to fiscal ideology, that suppresses internal consumption and wages to the benefit of the exporting elites”. A large surplus would normally partially self-correct via the exchange rate, but Germany “jammed the adjustment mechanism by launching the euro”, leading Washington to accuse Berlin of “gaming monetary union to lock in a stealth devaluation”.

Germany’s “original sin” was a collective refusal by elites to embrace modern technologies, says Wolfgang Munchau in The Times. As time went on, leaders “continued to double down”, with a heavy dependence on a few industries such as cars and chemicals and increasing reliance on Russia for gas and China for exports. The “neo-mercantilists in the government” turned a “bad bet by a single industry” – the car industry’s refusal to embrace the rise of EVs – into a “bad bet for the whole country”. Industrial production has fallen back to 2006 levels this year; the economy as a whole has seen virtually no growth since 2018. Unless Germany repeals its constitutional debt brake and starts to generate some domestic demand, it will “sink into atrophy”, says Evans-Pritchard. “The last chicken has come home to roost.”

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"The French economy has been getting away with fiscal murder for a very long time,” Raphaël Gallardo of Carmignac Gestion tells Bloomberg. For much of Emmanuel Macron’s pro-business presidency, France has been something of a market darling. But with a debt-to-GDP ratio of 111% and an annual budget deficit worth 6.1% of GDP, the country faces a stunning fall from grace. French government bonds have spent the past 15 years in a sweet spot, says The Economist. Global investors are keen on European debt. But the continent’s troubled southern economies were perceived as too risky, while tight-fisted northern states such as Germany and the Netherlands don’t issue many bonds. French debt fitted the bill. 

How does the rest of Europe compare to France? 

Things have changed. Southern Europe has been benefitting from a tourism-led growth boom, helping Greece, Portugal and Spain to get their spending in order. Once regarded as a proxy for ultra-safe German bunds, French debt is now priced less favourably than that of Spain or Portugal. In a more competitive European debt market, France’s “weak growth” and “volatile politics” are not very attractive. Its state spending equates to 59% of GDP, the biggest share in the OECD club of rich economies. Paris is paying €50 billion a year to service its debt load, a figure that could hit €80 billion come 2027, says Liz Alderman in The New York Times. The fiscal deterioration has been driven by spending sprees in response to the successive blows of Covid and the 2022 energy shock. An economic slump in Germany hasn’t helped. 

Macron’s decision to call early parliamentary elections this summer triggered a market re-think. The vote resulted in a hung parliament, with a national assembly split between mutually loathing left, centre and right blocs. Conservative prime minister Michel Barnier, who leads a “fragile” minority government, has an unenviable task. He needs to pass an austerity budget totalling €60 billion in cuts without displeasing either Macron’s centrists or Marine Le Pen’s party, on which he depends for tacit support. Barnier says that two-thirds of the “adjustment” will come from spending cuts, with a third from tax hikes on businesses and the wealthy, says Jean Pisani-Ferry on Bruegel.org.  

France’s fiscal watchdog disagrees: it calculates that, in reality, 70% of deficit reduction will come via new taxes. Tax hikes have been a red line during Macron’s presidency, but now that legacy risks being squandered. Equivalent to 1.2% of GDP, the planned retrenchment risks sinking an already “precarious recovery”. Growth is projected to hit just 1.1% next year, a far cry from the 5% figure France enjoyed during the post-1945 years of the Trente Glorieuses, or even the pre-financial-crisis norm of more than 2%, says Jean-Marc Vittori in Les Echos. Since 2008, growth has averaged a mere 0.9%. France hasn’t endured such a prolonged peacetime slump in living standards since the 19th century. After the economic “roller-coaster” of the pandemic and Ukraine, the French economy has returned to its baseline condition: “gloom”.    

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Europe’s super-technocrat Mario Draghi – the former chief of the European Central Bank (ECB) and Italy’s emergency prime minister in 2021-2022 – delivered a long-awaited report into Europe’s stagnant economy on 9 September, and what can be done to revive it. During the eurozone’s sovereign debt crisis, the erstwhile World Bank and Goldman Sachs economist was famed for vowing to do “whatever it takes” to protect the euro from collapse. 

His mammoth and rather chilling 400-page report, delivered last week to the European Commission in Brussels, is “a great deal more wordy” but delivers essentially the same message, says the Financial Times. Draghi wants a far more integrated, bloc-wide industrial policy focused on digital and clean technology and defence, plus more rapid decision-making if it wants to keep pace economically with the US and China. In addition, it will need a gigantic level of public and private capital to raise the proportion of GDP spent on investment by 4.7 percentage points (about 27%). This time, “whatever it takes” works out at roughly €800 billion a year.

Is Draghi's report too ambitious? 

Just a bit. Relative to the size of the economy, the 4.7-point uplift is more than double the size of the Marshall Plan to reconstruct Europe from the ruins of the Second World War. Such a change would require a world-historic effort that has never been seen before and a radical overhaul of the EU’s political processes. But then the crisis, says Draghi, is genuinely existential: If Europe cannot halve the current “slow agony” of economic decline, it faces a much poorer and more unstable future and political irrelevance. 

“For the first time since the Cold War, we must genuinely fear for our self-preservation,” says Draghi, and “the reason for a unified response has never been so compelling”.

Are things really that bad in Europe? 

Perhaps the most sobering statistic in Draghi’s report, The Future of European Competitiveness, is a projection: the EU’s demographics (the familiar problem of an ageing population) mean that unless the bloc can improve its productivity growth, its economy will be no bigger in 2050 than it is today. 

But there’s no shortage of other contenders for Draghi’s most scary data point. In 1990, the EU’s 12 member states accounted for 26.5% of the global economy. Today, its 27 states account for just 16.1%. Since 2000, real disposable income per capita has risen almost twice as much in the US as it has in the EU. And European productivity is now just 80% of America’s, compared with 95% in 1995.

Euro-optimists could certainly point to the role of currency movements when it comes to GDP data. For example, the strength of the dollar since the global financial crisis (the euro traded above $1.50 in summer 2008, compared with $1.11 in mid-september) means there’s a risk of overstating the difference between the economies, when measured in dollar terms, since the comparisons don’t account for purchasing power parity. Moreover, some analysis suggests that America’s superior growth is more due to workers’ willingness to work longer hours and take less time off, rather than productivity per se (where some EU nations have in fact outperformed the US average in recent years). Nevertheless, even by its own analysis, Europe’s prospects are undeniably grim, and competitiveness is at the root of the problem. “We claim to favour innovation,” Draghi writes, “but we continue to add regulatory burdens on to European companies which are especially costly for small and medium-sized companies and self-defeating for those in the digital sectors”.

What are Draghi’s solutions and could they work?

The headline solution is massively greater investment to fund an industrial policy to allow the EU to compete with the US and China, especially in clean tech, digital and artificial intelligence. But there are 150 recommendations altogether, ranging across ten “strategic sectors”, with detailed proposals, including a reformed and more integrated single market, the creation of a genuine capital markets union, energy market reforms, looser merger rules and streamlined legislative processes making it harder for member states to slow down and veto changes. Draghi also urges reforms aimed at strengthening the bloc’s currently fragmented defence sector, so that industrial policy also serves geopolitical ends in a more threatening world.

If a “wand could be waved” and everything that Draghi proposes were implemented, “there’s no question it would put rocket boosters” under Europe’s economy, says Carlo Martuscelli in Politico. But the chances of this happening are close to nil. 

Germany’s finance minister immediately rejected the idea of joint debt issuance at the EU level, for example (sparking a political row within the already fragile coalition). And even if some of Draghi’s reforms are eventually pushed through, the process is likely to be typically slow, rancourous and convoluted – especially given that the EU’s normal motors, Germany and France, both currently have weak governments.

How did EU leaders respond to the report? 

This potentially landmark report should have been a “wake-up call”, says Iain Martin in The Times. The EU’s leaders didn’t quite “hit the snooze button” and go back to sleep, but nor have they exactly leapt out of bed with any energy or purpose. 

The sorry truth is that Draghi’s good ideas – the most vital one being a capital markets union – will get “kicked into the long grass of future budget negotiations” and the vast majority of them won’t happen. That’s bad news for the EU and bad news for the UK. We are part of Europe, and its security and defence – underwritten by a strong economy – are our problems, too. “Without some burst of visionary statecraft or a historical lucky break”, the future for Europe is one of decline.

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“Thousands of angry left-wing protesters” took to the streets in France on Saturday in the “opening salvo” of what “could be weeks or months of demonstrations”, says The Observer. The protesters accused President Emmanuel Macron of a “denial of democracy” when he appointed the former EU Brexit negotiator Michel Barnier as prime minister, despite the fact that the left won the most seats in the recent elections and Barnier’s party won fewer than 50 MPs. 

The decision followed a two-month search for a PM, during which Macron ruled out the left’s preferred candidate (civil servant Lucie Castets) on the grounds that “she would be unable to muster enough cross-party support to form a stable government”.

Macron has pulled "a blinder"

The “absolute rage” being voiced by the French left suggests that Macron has “pulled a real blinder”, says The Telegraph. Barnier may be a “bit boring”, but unlike the alternatives, he won’t be immediately thrown out by a vote of no-confidence in France’s “new, unworkable parliament, with its three blocs of irreconcilable MPs”. Not having been seen on the “frankly unedifying” national political scene in recent years “is also an asset”, as is the fact that he ran for president two years ago on a “strong anti-unchecked immigration platform”. The selection of Barnier means that Macron has chosen “stability” over “revolutionary posturing”. 

While the far left is raging at what it sees as an “unacceptable coup de force”, the far right’s Marine Le Pen “has perhaps never been more powerful”, says Gavin Mortimer in The Spectator. She reportedly vetoed Macron’s two original choices, former Socialist PM Bernard Cazeneuve and centrist Xavier Bertrand, instead insisting on someone “respectful of the different political forces” and capable of talking to Le Pen’s party, the National Rally. The fact that Barnier’s centrist government needs the support of her 143 MPs to survive the inevitable challenge from the left “will give her bargaining power in parliament”.

What's next for France?

The left could have prevented this state of affairs if it had been willing to compromise by joining Macron’s own bloc in a “broadly centrist coalition”, says Lee Hockstader in The Washington Post. 

It’s hard to dispute there is something “Faustian” about Macron’s pact, especially as Le Pen has said that she will hold the government hostage to her party’s “hard-line agenda”, especially on immigration. Le Pen’s status as a “kingmaker” also gives her “respectability”, as well as putting a “yawning breach” in the “firewall” that mainstream parties had built to keep her out of power. 

Barnier’s selection “closes one tense and heated chapter” but “opens another, which could be even more testing”, especially given the “pressing need for France to get its public finances in order”, says The Economist. The new PM “will have his work cut out” as he tries to appoint ministers, make the necessary budget cuts, appease the left and keep the hard right quiet, as well as calm the streets. He will also have to do all of this while dealing with Macron’s “irrepressible tendency to interfere in all decision-making”.

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The far-right, populist Alternative for Germany (AfD) party is celebrating a “historic success” in local elections in the east of the country, says the BBC. The party topped the polls in the state of Thuringia, with almost a third of the vote – nine points ahead of the centre-right Christian Democratic Union (CDU). It also came a close second to the CDU in Saxony. This gives the far right its first victory in a state election since World War II. 

The AfD’s rise is “more troubling” than those of equivalents in France or Italy, says the Financial Times. While most hard-right parties in Europe have tried to moderate or at least downplay their most unsavoury elements, AfD members “openly espouse ethno-nationalist and xenophobic views”. The AfD leader in Thuringia, Björn Höcke, has previously been convicted of using banned Nazi slogans. 

"That nearly a third of voters in Thuringia and Saxony voted for it is deeply unsettling."

To make matters worse, another 10%-15% voted for “the populist hard-left Sahra Wagenknecht Alliance (BSW), whose anti-immigrant and pro-Russia stances chime with the AfD’s”.

Can the AfD last?

Other parties refuse to cooperate with the AfD, so the far-right won’t end up in power, and state governments don’t have any direct input on foreign policy anyway, says The Economist. However, the “large chunk” of seats the AfD now occupies will force the other parties into “ideologically garbled coalitions”. These are likely to include the BSW, producing state governments that are “precision-engineered for chaos”. 

Already, Sahra Wagenknecht, the BSW’s founder, is demanding that any coalitions that her party takes part in are committed to rejecting chancellor Olaf Scholz’s recent agreement to station long-range American missiles in Germany from 2026.

What does this mean for German elections?

These elections are an “emphatic slap around the chops” of the German political establishment, says Oliver Moody in The Times. The current coalition is deeply unpopular, while the established opposition has failed “to squeeze out the hard right”.

The fact that nearly half the voters in Thuringia and more than 40% in Saxony “have turned their backs on the established parties” suggests that “a large share of the electorate clearly feel that the political system no longer works for them”.

While Germany “is not in any sense heading back to the early Thirties”, politicians of the mainstream parties urgently need to “treat this warning with the seriousness it deserves”. 

At the very least, the mainstream German parties must stop telling voters, especially those in eastern states, that “their concerns aren’t real”, says Katja Hoyer in The Guardian. Particularly important issues include immigration, energy prices and the economy, as well as more generally “a deeper fear for the economic and political future of the country”. While such topics may be “uncomfortable” for centrists to discuss, ignoring them, or attempting to shut down discussion, effectively gives the AfD “a monopoly over those issues”. What’s more, it should be possible to have a “constructive debate” without “plunging into populism”.

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In Germany’s regional elections last week, the far right AfD party scored a major breakthrough in the east of the country. It capitalised on a failing economy and a revolt against mass immigration to come first in Thuringia and second in Saxony. The coalition of the Social Democrats, Liberals and Greens led by chancellor Olaf Scholz now looks certain to lose power next year, and may well struggle to last that long. 

When that happens, the country will face a political stalemate, with none of the major parties willing to work with the AfD, nor able to govern without them. The result will be a political mess, against the backdrop of a slow-motion economic crisis. The latest data at the end of August showed the economy shrinking yet again, with output falling by 0.1% in the past quarter. Investment in Germany fell sharply, as did consumer spending. It was only rising government spending that limited the decline. Germany is the slowest-growing economy in the G7, and another recession by the end of the year looks certain.

Germany's structural crisis

Yet the problem goes far deeper than that. Germany is not simply experiencing a cyclical downturn, but a structural crisis. Demand for its exports has powered the economy for much of the last 20 years. Germany supplied the machine tools that transformed China into the second-largest economy in the world. However, that opportunity is now slowing down rapidly as the process is completed, and as Chinese manufacturers compete against German firms in their market. Meanwhile, the switch from petrol to electric vehicles is destroying the mighty automotive industry on which it depends for its prosperity. Only this week Volkswagen raised the prospect of closing some factories for the first time in its history as sales struggle to match expectations. At the same time, there is no sign of new industries emerging to replace the old ones. 

To make matters even worse, the country made a big bet on cheap Russian gas to power its heavy industry, closing down its nuclear power stations. The result: its energy is now mostly imported and it is twice as expensive as in the United States. That would be painful enough if Germany were a services-based economy such as the UK. For a manufacturing one, it is a crippling burden to carry.

No easy fix for Germany's woes

There is no easy fix to these problems.

There is no immediate replacement for cheap Russian gas. Germany is building green energy, and wind power has risen to 22% of its electricity capacity, but it is still behind coal at 27%. Nuclear power stations take at least five years to build, if not more, and the political establishment is still completely opposed to them. So Germany’s power will remain among the most expensive in the world for many years. 

The EU might loosen the rules a little on phasing out petrol cars, but with strict net-zero targets, it is too late to save the car industry and the 800,000 jobs it sustains now. The damage has already been done. Likewise, although Germany is one of the most technologically brilliant countries in the world, it is so far behind in the race to create digital industries that it will be very hard to create them now. 

Worst, there is no sign of the political leadership that reform would need. The AfD and the far-left Wagenknecht party campaign on immigration. They have nothing of significance to say about lowering taxes, reducing red tape or restoring competitiveness. None of the mainstream parties will work with them, yet they will not be able to form a majority on their own. With no stable government, nothing can be changed. 

So Germany is trapped in a structural slump that will last for a decade or more. Weak demand in what was once the powerhouse of the continent will depress the entire eurozone. It will become more and more reluctant to pay the bills for the rest of the EU. Its politics will become more and more unstable, and extreme, perhaps reviving memories of the chaotic 1920s. At some point, Germany will reinvent its economy – but it will be a long wait.

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In June this year, the North Atlantic Treaty Organisation (NATO) celebrated its 75th anniversary. A pact that was formed in the aftermath of World War II to counter the threat of the Soviet Union has now outlived its adversary by more than three decades.

In that time, NATO’s role has evolved from the defence of Europe to a much broader purpose, starting with military intervention in the former Yugoslavia in the mid-1990s. Article 5 – the part of the NATO treaty that requires participants to aid any member who is attacked – was evoked for the first (and so far only) time not for a war in Europe, but to deploy troops to Afghanistan after the September 11 attacks on the US. 

Yet any sense that NATO’s members have kept up with the times ended after Russia invaded Ukraine in February 2022. For a start, we once again have a major war in Europe, on the very borders of Nato. That in itself could be seen as a long-term failure of international relations. But, more importantly, it has shown that many NATO members have been slow in recognising the changing realities and how far they will have to go to remain relevant in the next decade. 

So as NATO celebrated in Washington two months ago, it formally welcomed two new members, Finland and Sweden. Their decision to join NATO after decades of neutrality showed how Russia’s aggression has reshaped the security situation. Yet to make a practical difference, much more concrete steps that involve a lot of money will be needed. 

NATO’s members have spent three decades living off the legacy of the end of the Cold War, drawing the “peace dividend” and running down investment in their military. Their efforts to support Ukraine are already making the inadequacy of the European military-industrial base all too apparent. Many countries are – belatedly – starting to ramp up and modernise their military capabilities. This should create massive opportunities for the defence industry.

Europe's military spending

When the Soviet Union was dissolved in 1991, the West celebrated what it believed to be “the end of history”, in the words of political scientist Francis Fukuyama. For a long time, that optimistic view of the world looked likely. Since the break-up of Yugoslavia, continental Europe had not been involved in major wars at its borders. Russia had embraced capitalism, and after a period of post-Soviet chaos under president Boris Yeltsin, its future under a young Vladimir Putin looked more stable. China entered the World Trade Organisation in 2001 and looked to be on track for a future of free markets and eventual democracy. The world appeared much safer, with the prospect of greater harmony and cooperation between major powers. 

Military spending declined as the Cold War ended: from $1.6 trillion in 1988, it dropped by a third in the 1990s, after adjusting for inflation, according to the Stockholm International Peace Research Institute (SIPRI), a think tank. Then it began to increase again, doubling since 2000 and reaching a record total of almost $2.5 trillion last year. However – and significantly – this increase was uneven. Military spending did not increase much in the West. Despite the vast cost of the wars in Iraq and Afghanistan – reportedly over $2 trillion each – the US now spends 3.4% of its GDP on defence, close to the lowest level since World War II. For comparison, it averaged 5%-6% in the seventies and eighties. 

Meanwhile, most European countries sought to reduce military spending further in the aftermath of the global financial crisis and the eurozone debt crisis. The role and value of national defence was sometimes questioned, especially for Greece during the Euro crisis (Greece spends a surprisingly large amount on defence due to its rivalry with Turkey). Many countries made decisions to cut back on capabilities that no longer seemed strategic: the Netherlands got rid of all its tanks. Overall, Western European spending has decreased by 4% since 1990 in real terms, according to SIPRI. 

France, one of Europe’s key military powers, provides many examples of such decisions that now seem short-sighted. Let’s take two. In 2007, it shut down the production line for its main battle tank, the Leclerc, manufactured by state-controlled Nexter. As a result, France is now having to modernise existing units to bring them up to modern standards and some experts are sceptical that this “retro-fit” is enough given lessons from Ukraine. In 2017, the military budget suffered a shock €850 million cut under a short-termist attempt to meet EU budget deficit rules, despite president Emmanuel Macron consistently promising to boost spending significantly. That choice, which is hard to comprehend given that overall debt has exploded by €1 trillion under Macron’s presidencies due to social spending, led to the resignation of Pierre de Villiers, the straight-talking general who headed the French armed forces. “In the current circumstances I see myself as no longer able to guarantee the robust defence force I believe is necessary to guarantee the protection of France and the French people, today and tomorrow, and to sustain the aims of our country,” he said. 

After three decades of this, the war chests are empty across Europe. There are a few cutting-edge pieces of technology, but too much equipment is both outdated and supplies are sufficient for short skirmishes only. Long gone are the days when statesmen with foresight, such as Jean-Baptiste Colbert, planted forests of slow-growing oaks so that the next generations could build ships to defeat la perfide Albion on the high seas. 

In fact, the reality is that perfidious Albion has still been spending more than most of Europe, despite some recent mishaps, such as the troubled and pricey Ajax armoured vehicle programme. Defence spending amounted to £54 billion in 2023, nearly twice the level of 2000 and equal to 2.3% of its GDP. Operations in Iraq and Afghanistan provided shocking illustrations of the shortcomings of some equipment – eg, composite armoured Land Rovers were inadequate to protect soldiers against landmines – but this experience led to it being upgraded. Some major investments were also made: in 2008, the aircraft carriers HMS Queen Elizabeth and HMS Prince of Wales were commissioned for a total cost of £6.2 billion-plus £13 billion for 48 F-35 fighters (although some critics say it spent so much on these that it can’t afford other ships that the Royal Navy needs).

Keir Starmer has recently reiterated a “cast-iron commitment” to spending 2.5% of UK GDP on defence, in line with the previous government. Of course, this still does not look like enough. There are regular stories that show the UK armed forces as short of resources and personnel, hence reports – since denied – of the possible mothballing of the assault ships HMS Albion and HMS Bulwark earlier this year. Rumours that the Tempest next-generation fighter project – a collaboration with Italy and Japan – might be ditched in the government’s defence review simply on cost grounds is yet another example of one of Britain’s greatest flaws: the “Treasury brain” thinking that leads governments to cut back on important long-term investment in order to make the public finances look better in the short term. However, the trend is clear. Britain and other European countries realise that they will have to spend more, even if they are dragging their feet on the amount.

Military spending rises globally

The US is still the world’s biggest military spender, at a colossal $860 billion a year. This is nine times as much as Russia and three times as much as China in terms of declared spending. But some analysts think China has much higher unreported spending and its budget could be almost on par with America. Even on official figures, China has increased military spending by 50% since 2016 and by a factor of 13 since 2000. This is a major part of why the US has fallen from 50% of world military spending before 2008 to 37% now. 

The increase in Chinese military spending, together with growing aggressiveness towards other countries, especially in regional waters, is a wake-up call for Western powers. So too must be the way that Russia has put its economy on a war footing to sustain its attack on Ukraine. Much of Russia’s Soviet military legacy is decaying and dilapidated: think of the Admiral Kuznetsov, its single aircraft carrier and flagship, belching black smoke as it transited the English Channel in 2016, the nuclear submarines rusting away in the Kara Sea close to the Arctic, or videos of ancient tanks and vehicles deployed on the battlefield in Ukraine. On the other hand, Russia continues to sustain its assault on Ukraine despite expending vast amounts of material (showing that its supply base is holding up in the face of sanctions) and show off its development of advanced weapons, such as Kinzhal hypersonic missiles. 

So the case for greater defence spending in the West is being made daily. At the same time, there is a growing belief in America that its commitments – including around 750 bases in 80 countries – mean that it is footing an unfair share of the bill. Donald Trump made a big deal of pressuring other NATO members to raise their defence spending during his presidency, calling them “freeloaders”. If he wins again in November, we can expect renewed shots at many allies about this – last month, he called for Taiwan to pay for its own defence. Whether these comments are all reasonable and whether Trump has a coherent military strategy is irrelevant. Those kinds of views are not limited to Trump and pressure for America’s allies to spend more are only likely to grow in the medium term.

NATO members have already increased spending, by 9% in 2023 and 18% in 2024. Some 23 out of 32 members are now meeting their stipulated minimum level of annual defence spending (2% of GDP), up from 10 members in 2023. Yet this does not go far enough. Europe is becoming more conscious that it cannot rely on the “Pax Americana” forever. A more isolationist America, under Trump or a future leader, would be a less reliable guarantor of global security. Hence the European Commission’s defence industrial strategy, which was set out for the first time earlier this year, calls for Europe to be more independent from other suppliers. Whether that will be achieved is debatable; it is also obvious that it shouldn’t happen at the expense of cooperation with partners such as the US and Japan. However, any moves in this direction will mean creating more of its own defence infrastructure, from raw material sourcing to production and technology, including unmanned aerial vehicles and cybersecurity. 

Total European defence spending could rise to €500 billion per year by 2028, from around €300 billion in 2022, according to consultants at McKinsey. This will include significant increases by countries such as Poland, which has been the first to lift spending above 4% of its GDP (with a 75% increase in 2023 alone). It is acquiring F-35 fighters from Lockheed Martin to help secure its airspace against Russia’s Sukhoi Su-35s and is also considering the Eurofighter Typhoon (Airbus, BAE Systems and Leonardo) and the F-15EX Eagle (Boeing). France is waking up: it will collaborate with Germany on a new tank to replace the Leclerc (and Germany’s Leopard II) and also plans to construct a new aircraft carrier to replace the Charles de Gaulle. All this will take time, but the process is under way.

Will Europe pull its weight in NATO?

However, perhaps the crucial reminder from the invasion of Ukraine is that defence is not just about new technology. In war, countries need a manufacturing base to keep pace with demand. Russia is bombarding Ukraine relentlessly, firing an estimated 10,000 shells a day. None of the NATO countries could keep up that pace for even a few days. When the West was focused on the “war on terror” and guerilla conflicts, it produced small batches of varied munitions for low-intensity conflicts, and neglected volume. Supplying Ukraine has depleted its stockpiles. That’s why Germany’s Rheinmetall has recently received the largest contract in its history, worth up to €8.5 billion, to produce more of the 155mm shells that equip all NATO artillery. This aims for 100,000 shells a year from the second year of production, and eventually 200,000 per year. 

This increase is still nowhere near what’s needed to rebuild stockpiles and supply Ukraine. Other suppliers are also adding capacity. Europe is aiming to be producing two million shells per year by the end of 2025 and the European Commission says the production rate now stands at one million per year. Yet reports suggest actual output may be about half that. This one example shows how much will be needed to build up Europe’s neglected defence base – but also the potential investment opportunity if countries come together to rebuild their capabilities and pull their weight in NATO.

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When we talk about the outlook for interest rates, my rule of thumb is simple: central banks are likely to be slower to start cutting than markets initially expect, but end up cutting deeper. This sounds like a very broad generalisation, but if you look at month-by-month charts of interest rates over the last few cycles (say 30 years) versus market expectations for where rates would go in future (taken at the same historical point – so a snapshot of what investors thought at the time), a loose pattern looks pretty clear to me.

When rates are approaching a peak, markets tend to keep assuming that they will go a bit higher than they eventually do. After the central bank pauses, they tend to assume cuts are coming soon. Once cuts begin, they assume rates will bottom out higher than expected, then start rising again sooner (although in the last tightening cycle, markets expected a slower pace of hikes in 2022 than they eventually got) – but with a lower peak – until they finally catch up with reality just as the peak approaches.

What can we expect from central banks?

Central banks are now in a cutting frame of mind. The Fed cut interest rates by half a percentage point last month and looks certain to cut again in November. At 2.4% in September, US inflation has fallen a long way and poses no barrier to this, regardless of the month-to-month noise. In the UK, September inflation was at 1.7%, below the 2% target, and most of the Bank of England rate setters seem even keener to get rates down than the Fed. Likewise, the European Central Bank.

Significant rate cuts are now priced in over the next year or so and will probably once again go further than expected. What happens after that is unpredictable. If inflation stays low, so will rates. If it threatens to roar back, memories of 2022 will have central banks tightening more quickly. Last decade, we had no price inflation despite very low interest rates. We can’t ignore the same possibility this time. Rates could head to 2% or lower for the long-term. However, fiscal policy was very tight back then. Now it is becoming looser, especially in the US.

Cheap Chinese exports have helped hold down global inflation for two decades. This continues for now, but is making trade tensions worse and is likely to lead to inflationary tariffs. The world looks more unstable and more prone to shocks. So, structurally higher (but volatile) inflation and rates seem likely. What happens after central banks ease this time will be the first test of that.

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“Germany is struggling,” say Kevin Fletcher, Harri Kemp and Galen Sher in an IMF blog. The world’s third-largest economy was the only G7 member to contract last year and looks set to be the group’s slowest-growing economy again this year. 

Still, the idea that an economic model built on manufacturing and cheap Russian gas is “irreparably broken” is overstating things. Wholesale gas prices have now returned to 2018 levels. The chemicals, metals and paper industries were hit hard by the energy crisis, but they only account for 4% of the economy. Electric vehicle (EV) exports rose 60% last year – VW and BMW alone account for over 10% of global EV sales.

Germany's economy

Germany is still running a trade surplus equivalent to 4.3% of GDP – above the average of the last two decades and hardly the sign of a declining industrial power. While industries like chemicals decline, high-value-added activities – especially in research and development – aren’t going anywhere, Robin Winkler of Deutsche Bank tells Jonathan Packroff for Euractiv. 

That said, a “second year of near-recession” is taking its toll, says Packroff. Insolvencies rose 41% in the first half of the year, an unusual trend in a country that rebounded quickly from shocks such as the 2008 crisis. Things should improve as the global trade cycle turns, says Martin Wolf in the Financial Times. But deeper structural problems are becoming a source of concern. 

The ageing population will see growth in the German labour force lag other G7 members for the rest of this decade. Deglobalisation raises acute questions for Germany’s export-based economic model and the country is woefully behind in digitalisation. In the UK we complain about creaking infrastructure because public investment has been a measly 3% of GDP in recent years – but in Germany it has been even lower, at 2.5%. 

Germany's stock market

Germany’s stock market lacks “breadth” compared with European peers – smaller, family-owned companies tend not to list, leaving Frankfurt the preserve of large-cap multinationals, says Jan Schildbach in a Deutsche Bank Research note. Dax-listed companies earn more than 80% of revenues outside Germany.

But for all the gloom, investors should remember that “European equity performance has been far better than economic performance”. On a total return basis (including dividends), the Dax has returned nearly 6% a year since early 2007, beating the UK and French markets (both 5.5%) over the same period.

That’s thanks to Germany’s slightly higher weighting towards the technology sector. Since 2013, German initial public offerings (IPOs) have raised the most capital of any European market except for London. Often maligned, German stocks are arguably Europe’s “hidden champion”.

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Our investment philosophy is to look beyond the economic and political noise to find continental European companies that can deliver superior returns over a three-to-five-year horizon. We look for firms that can deliver sustainable dividend growth, as history shows us that this characteristic is a marker of quality that can help to identify stocks likely to outperform the market. We seek to build a balanced portfolio and look for the best companies across sectors, favouring stocks with strong balance sheets, pricing power and a robust competitive position.

Top European stocks to invest in

Epiroc

Sweden’s Epiroc (Stockholm: EPI-B) is a global leader in underground and surface rock drilling. The company operates in an oligopolistic market and benefits from a very strong competitive position. Epiroc is well placed to capitalise on future commodity booms fuelled by long-term trends such as electrification and the growth of infrastructure. Meanwhile, a decline in the quality of ore is leading to a shift towards underground mining, which benefits Epiroc more than its peers owing to its superior product mix. The group’s customer base is extremely fragmented, which creates pricing power, and Epiroc also enjoys the benefit of repeated part replacements. As mining becomes more complex, Epiroc should be able to pass through higher prices and increase volumes. Epiroc is cash-generative and has low net debt, with an attractive and sustainable dividend. Given these positive fundamentals, we anticipate that Epiroc will be able to deliver high single-digit organic growth over the next five years.

Ryanair

Ryanair (Dublin: RYA), Europe’s largest low-cost air carrier, is the strongest player in a highly commoditised market. It has the best cost-management discipline of all European airlines and has historically delivered industry-leading returns on equity. The company has been the main European beneficiary of the post-pandemic recovery in demand for air travel as other suppliers (such as Wizz and Vueling) have struggled to boost supply due to their reliance on the delivery of new aircraft. This has supported pricing. Having stopped paying dividends during the Covid pandemic, Ryanair has recently announced a new dividend policy and share buyback programme. Emboldened by a secure balance sheet (the company has no debt) and high levels of cash generation, management has signalled its confidence in the firm’s ability to fund both buybacks and a progressive dividend policy.

Bankinter

Bankinter (Madrid: BKT), a Spanish domestic bank, is an example of where we like higher quality, best-in-class companies that operate in an otherwise average market. Management has a strong record of capital allocation and the business pays an attractive, mid-single-digit dividend yield. The shares are highly sensitive to interest rates, but we think the long-term outlook justifies this potential volatility. Bankinter is one of the few banks in developed markets where we see genuine opportunities for organic growth, thanks to its client mix and focus on high-net-worth individuals, along with the backdrop of consolidation and restructuring happening in the wider Spanish market. This enables Bankinter to gain new clients through attrition as other players combine. Meanwhile, management has been investing in emerging operations in Portugal and Ireland to drive future growth.

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Milan has always been Italy’s financial centre, but it has never had much of a role on the global stage, and as Italy’s economy has stagnated over the last 20 years, even its domestic role has not amounted to very much. Over the last few months, however, there are signs that Milan’s reputation is starting to change. 

Last week, we learned that the private equity firm Three Hills Capital Partners was backing plans to open a private-member’s club in Milan, modelled on London’s Soho House chain. Its aim is to provide a networking hub for all the finance professionals moving to the city. The hedge fund Capstone opened up an office in Milan in January, and Eisler Capital, Andera Partners, Arcmont Asset Management and Certares Management have all established a presence in Milan over the past few years. 

Major global banks, such as Goldman Sachs and JPMorgan, are expanding their trading operations there too, and Barclays moved into a new office in the city in 2022. Meanwhile, initial public offerings (IPOs) on the stock market are recovering. 

Milan won the listing of the footwear brand Golden Goose, with a float worth almost $2 billion, and although its private equity owners pulled the deal at the last minute due to political turmoil across Europe, it is still likely to list in Milan eventually. In total, there were 39 new listings in Milan last year; admittedly, that is hardly a fantastic total, but it is more than London managed. Add it all up, and one point is clear. Milan is seeing a significant revival as a major financial centre. There are three reasons for that. 

First, it has some very generous tax breaks, so long as you are not Italian. Anyone moving to the country can opt to pay a flat rate of €100,000 on their global income, and the rest of it is tax-free. Sure, that might seem like a lot of money to most of us, but if you are earning £1 million a year, as a small group of very successful people in finance do, then it is a pretty good deal. You pay £84,000, the current rate, in tax, and the rest you can keep. 

It is a lot less than the 45% in income tax you would pay in London, especially if the new Labour government changes the rules on “carried interest” for private equity executives so that the money they make is taxed as income instead of as a capital gain. Italy has crafted a smart set of tax breaks that make it an attractive destination for genuinely high-earners, but that limit the numbers. With taxes going up everywhere else, that is going to make Milan an increasingly attractive choice.

How does Milan compare to its Europe counterparts?

Next, other financial centres have started to become a lot less welcoming. London is the most obvious example, with a crackdown on non-doms, the taxation of private equity partners and possibly a big increase in capital gains tax as well. It had already been turned into a relatively high-tax location under the Conservatives, but under Labour it will become even less friendly towards finance. Its main rival in Europe – Paris – is going the same way. 

Germany may well be heading for the same sort of political crisis as France, which will make Frankfurt less attractive as well. Against that backdrop, a low-tax Italy, with relative political stability, looks very appealing.

Finally, Italy is growing again. By the end of 2023, its economy was 4.3% larger than before the pandemic, the strongest recovery of any of the major European countries, and ahead of Britain, Germany and France. It is forecast to expand by another 1% this year. Hardly a turbo-charged rate, but still significantly ahead of the 0.7% rate forecast for the eurozone as a whole. 

After two decades of stagnation, that is a significant change. Sure, it received huge funds from the rest of the EU as part of the Covid Recovery Fund, and as that wears off its growth may weaken again. Even so, it means that the local economy is stronger and generates more business. Add in a great lifestyle, with excellent food, lots of stylish shops, and easy access to stunning lakes and beaches, and Milan has a lot going for it. Piece by piece, Milan is turning into a genuine alternative to London, Paris and Frankfurt – and it may soon turn into a real threat.

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There were “gasps of horror” and tears from Marine Le Pen’s supporters following an “unexpected left-wing victory” in the second round of France’s parliamentary elections, which thwarted her efforts “to bring the far-right to power”, says the Financial Times. 

The result represents a “resounding success” for the co-ordinated strategy against the National Rally (RN), which saw centrist and left-wing candidates withdrawing in order to encourage tactical voting against Le Pen’s party. 

It was pushed into third place with 143 seats, while president Emmanuel Macron’s Ensemble coalition got 159 and the left-wing NFP topped the polls with 180 seats. Still, this gives the RN significantly more than the 88 MPs it had previously, and leaves France in “limbo”, and no one party with an overall majority.

What does the French election mean for France's stability? 

The hung parliament, with three powerful blocs, constitutes “uncharted waters” for France, says Charles Bremner in The Times. There is precedent for “cohabitation” between a left-wing PM and a more conservative president, but the NFP bloc is so divided it can’t agree on a leader. Macron considers Jean-Luc Mélenchon and his France Unbowed, the largest party in the NFP, as “every bit as dangerous” as Le Pen’s RN. 

This leaves Macron scrambling to attempt to “forge a working coalition between his centrists and moderate left-wingers”, which means that “long negotiations of a kind not seen in France for decades” are expected. There is “no clear or immediate path” to a stable government, so any coalition that does emerge is likely to be solely “designed to keep the machinery of government running rather than to enact big reforms”, says The Economist. 

Such an arrangement would at least “bring stability”, something that would be welcomed by the markets. However, it might also lead to a backlash that boosts the extreme left and right – “French voters are already distrustful of Macron’s outgoing technocrat-heavy team”.

The impact on Europe

France’s expected post-election “paralysis” is also likely to temper any relief felt in Brussels at the results, say Barbara Moens and Jacopo Barigazzi for Politico. Eurocrats will be “delighted” at the relatively poor performance of Le Pen, but they will be worried by the anti-EU rhetoric coming from both the French left and the right. They will also be concerned that an inability to carry out further fiscal reforms will lead to economic “stagnation” and a worsening financial situation, resulting eventually in a confrontation between Paris and Brussels over the French deficit. 

Macron’s authority and influence has been “greatly diminished”, which is bad news for those who support his belief that Europe, in an “overheating” world, needs to show “more unity, more coherence, more power”, says Timothy Garton Ash in The Guardian. It is also unfortunate for Ukraine, given that Macron was “the most influential west European voice in favour of increased support” for the “embattled” country, whose fate still hangs in the balance. Macron has “stabbed both himself and Europe in the back”.

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French voters went to the polls this weekend in the second round of France’s snap legislative elections, with its centrist president, Emmanuel Macron, facing disaster and humiliation – and France facing months of political stasis and economic turbulence. 

Following the resounding victory, of Marine Le Pen for the hard-right National Rally (Rassemblement National, or RN) in the European Parliament elections less than a month ago, Macron stunned allies and opponents alike by announcing an immediate general election. 

Macron wanted to seize the moment and take the battle to the far right, with the aim of uniting the centrist bloc, dividing the left, and isolating the RN. Rather than a bold tactical manoeuvre, it has proved more of a reckless gamble.

French election first round

French voters flocked to the polls in the first round, delivering the highest turnout in decades and the RN taking a record 33% vote share. A hastily assembled left-wing alliance, the New Popular Front – taking in socialists, greens and communists – was second with 28%. Macron’s centrist coalition, Ensemble, limped home third with just 21%. 

Under the French electoral system, a candidate getting 50% wins outright. Otherwise, the top two candidates in each constituency, plus any other candidates getting more than 12.5% of registered voters, go forward to the second round. In the first round, the RN placed first in 296 seats – enough to give it a parliamentary majority (meaning 289 seats in the 577-seat National Assembly) if it could repeat the feat in the second round.

French election second round results

With all eyes on France, a “Republican front” effort has risen up to stop the RN. More than 200 third-placed candidates from the left-wing alliance and Macron’s centrists dropped out to leave a straight fight between the RN and one other candidate. Analysts expected the RN to be the biggest party, but to fall short of a majority. But, on Sunday, 7 July, in a shock second-round twist the left-wing coalition won the day, with the RN pushed into third place. 

Despite (or, perhaps, because of) that, there's likely to be political turmoil for months. Since the left-wing alliance failed to win an outright majority a hung parliament, and political gridlock, loom. Not least because there's a constitutional bar on calling fresh elections for another year.

Has Macron been a good leader?

From the point of view of business and investors, his presidency to date has seen a “sustained effort to remake France as a modern, business-friendly economy” and has been a broad success, says The Economist. Since 2017, Macron’s governments have reformed labour laws, making it easier to take on workers; two million jobs have been created and more than six million businesses set up. Macron has cut business taxes and wealth taxes, “boosted education and started to reform the unaffordable pension system. France’s growth is above the eurozone average, and poverty rates below it.”

Why is Macron getting kicked by voters? 

It’s partly the terrible timing of an election three years earlier than needed, on the back of defeat in the European elections – traditionally a chance to give incumbents a kicking. It’s partly the unforeseen ability of the left, normally hopelessly divided, to quickly form a united front. And it’s partly the backlash against what many voters see as Macron’s arrogant, elitist manner and unpopular reforms, especially on pensions. 

The other crucial factor is the transformation of the RN, formerly the National Front, which over the past decade has shifted from its openly racist and quasi-fascist roots into a hard-right nativist party with a broader appeal, exemplified by its young candidate for prime minister, Jordan Bardella, aged just 28. 

“There is now a sizeable share of the mainstream right that would consider voting for the National Rally – or at least no longer sees it as a threat,” says pollster Stéphane Fournier. “That is especially the case when the other candidate is from the left, which many conservatives are more scared of.”

How did markets react to round one?

After the first round, Monday 1 July saw a classic relief rally, as markets judged that the RN had slightly underperformed expectations, making an outright RN majority less likely. The CAC-40 index rose 2.4% in early trading – its best daily performance for two years – with bank stocks in particular surging, led by Société Générale and Crédit Agricole. 

Bond prices, which had fallen during the campaign, began to rise again. But that burst of initial optimism is likely to prove misplaced, says the Lex column in the Financial Times. 

Investors are betting that political gridlock would be a better option than an RN government, which is promising a fiscally reckless programme of protectionism, welfare spending and unfunded tax cuts – including slashing VAT and exempting anyone under 30 from income tax. The underlying reality, though, is that France is facing a prolonged period of great political uncertainty, and entering it with exceptionally high debt levels – a potentially toxic mix.

How much debt does France have?

Total government debt has reached 112% of GDP, up from 66% two decades ago and among the highest of rich countries after Japan and the US, both of which are far larger economies. Its current government deficit is more than 5% of GDP, and its credit rating has been downgraded twice in months. 

Already, the spread of French government bonds over their German equivalents is close to multi-year highs, reflecting the fragility of investor sentiment, says Neil Shearing of Capital Economics. The fear is that a “fiscally incontinent” RN government would cause a repeat of the crisis that hit the UK in the autumn of 2022. That’s a worry, since France is not just the eurozone’s second biggest economy but the world’s fourth largest bond market.

What's the wider impact?

The thing about deficits is that they don’t really matter – until the bond market decides that they do, says Pierre Briançon on Breakingviews. The prospect of a lame duck president, and either a 28-year-old hard-right prime minister with gigantic spending plans, or a centrist technocrat with no real mandate or authority, means instability is looming. 

This is “not just a crisis for France” – but for the whole of the EU, says Andrew Neil in the Daily Mail. France will have a parliament – and perhaps even a new government – packed with eurosceptics and politicians who “despise the soft-left technocratic consensus that rules in Brussels”. Macron is a “busted flush”, and with Olaf Scholz limping on as chancellor of Germany, Europe will be “bereft of leadership” at a time of geopolitical peril. 

The UK, meanwhile, is moving from one majority government to another, with a minimum of fuss. Britain, for all the clamour and rancour of the election campaign, suddenly seems an “island of stability”.

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Nationalist and right-wing parties won major gains in last week’s European elections, says Bruno Waterfield in The Times. They punished France’s Emmanuel Macron and Germany’s Olaf Scholz, “badly weakening” and even “humiliating” the two leaders “who were at the heart of running the EU”. 

Indeed, Macron’s results were so bad that it prompted him to make the “unprecedented” move of calling snap French parliamentary elections. Similarly, Scholz’s SPD party came third, behind the centre-right CDU and the hard-right AfD – its “poorest result in a nationwide election since reunification”. Elsewhere, there was “a continuing consolidation and overall gains for eurosceptics and hard-right parties”.

European elections: a reality check for incumbents

European voters in Germany and France clearly delivered a “stinging rebuke” to the incumbents, says The Economist. However, the broader hard right takeover of the EU that was predicted by some does not appear to have happened. 

The new parliament will “lean further to the right”, but the wider shift to nationalist parties failed to materialise in many countries. In Holland, Geert Wilders, for example, the “hard-right firebrand” who won the most votes in national elections in November, “lost to centrist adversaries”, while the far-right nationalist Vlaams Belang party failed to top the polls in Belgium. 

Further evidence that this was a “vote against incompetent mainstream parties that promise much but deliver little”, rather than a “pro-right surge across Europe”, comes from the fact that socialists won the largest share of the vote in Malta, Romania and Sweden, says The Telegraph. This has helped the centre-left retain its position as the parliament’s second-largest group, albeit as a far weaker player than in the 1990s. 

Overall, the far-right bloc seems to have increased its number of seats only slightly, with pro-EU centrists, greens and socialists still holding on to a majority of seats. This “boosts the chances of Ursula von der Leyen securing a second term as European Commission president”.

What can Europe expect from right-wing parties? 

The populist, far-right parties could still have a bigger hand in European policymaking over the next five years, however, says Karen Gilchrist of CNBC on MSN. Centrist parties will now be more dependent on the right for key votes in the 720- seat European Parliament, and we can expect an “emboldened” ID party, the far-right grouping in the EU, to apply pressure on contentious issues. 

This obviously includes immigration, expected to be “front and centre of the policy agenda in the next parliament”, but might also affect green policies, industrial strategy, defence and EU enlargement. 

The rise of the hard right not only “greatly complicates getting united, decisive action from the EU on issues such as the green transition”, but also poses a threat to Ukraine, says Timothy Garton Ash in The Guardian. The right is divided on this issue – Italy’s Giorgia Meloni is a supporter of Ukraine – but the “net impact of these results will be negative”. Scholz’s party is already showing signs of wanting to “appease”’ the quarter of Germans who voted for parties that want to end the war. 

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French president Emmanuel Macron “is going for broke”, says Clea Caulcutt for Politico. Macron’s centrist party received a drubbing at the weekend’s European elections, securing just 14.6% of votes, less than half the figure for Marine Le Pen’s National Rally party. Rather than retreating to lick his wounds, Macron has shocked his own allies by calling a snap parliamentary election three years ahead of schedule. 

This “maverick gamble” appears designed to knock Le Pen “off her stride”, but could well backfire. There are “echoes” of David Cameron’s attempt to silence Conservative eurosceptics by calling the Brexit referendum. 

In a few weeks’ time, France could be run by its first far-right government since the Second World War. Jordan Bardella (pictured), Le Pen’s 28-year-old protégé, would become prime minister. Periods of “cohabitation”, with a president and prime minister from opposing parties, are not unprecedented, although one hasn’t happened since 2002. 

This scenario would see Macron, as president, retain control over foreign and military affairs, says The Economist, while a National Rally government would run domestic and economic policy. Historically, “French prime ministers tend to get the blame for everything that goes wrong, while presidents can float above the fray”.

How are markets reacting to the early election? 

Markets reacted sharply to news of the snap poll. The euro fell against the dollar on Monday, while the CAC 40 stock index dropped 2.5% over the first two trading days of this week. France’s ten-year bond spread against Germany climbed to its highest point this year, a sign investors think lending to the French government is getting riskier. 

French bank shares fell particularly hard on Monday, says the Financial Times. The sector could be targeted by windfall taxes. The National Rally’s “protectionist, big-spending agenda could put Paris into conflict with Brussels and alarm investors”. Two scenarios appear possible, Stéphane Déo of Eleva Capital tells Sophie Rolland in Les Echos. Either the National Rally wins enough seats to form a government and implement its free-spending policies, or the elections produce a hung parliament, with limited coalition options, in which case France risks “becoming ungovernable”. 

While financial markets have already reacted strongly, they do not seem to have fully priced in the risk of political chaos ahead. French public-sector debt sits at 110% of GDP, says Melissa Lawford in The Telegraph. Ratings agency S&P Global recently downgraded the country’s sovereign debt rating. Le Pen’s costly plans to reduce the retirement age and cut taxes would hardly help matters. If bond markets revolt, then France could find itself heading for its own “Liz Truss moment”. 

There is one glimmer of hope for European equities. Last week the European Central Bank (ECB) cut interest rates by 0.25 percentage points, the first reduction since 2019 – and cheaper money usually boosts stock prices. The ECB’s move breaks a 25-year precedent, says John Authers on Bloomberg. Since its inception, the Frankfurt-based bank has never cut rates unless the US Federal Reserve had already done so first. But with America still contending with sticky inflation, the ECB is “setting out on its own”.

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The European Central Bank (ECB) has cut interest rates for the first-time in five years, raising hopes that the Bank of England will follow suit.

The cost of borrowing in the Eurozone has been reduced from a record high of 4% to 3.75%, with the ECB citing progress in tackling inflation but it refused to commit to further cuts.

The ECB's decision follows Canada, Sweden and Switzerland where the central banks have all cut rates recently.

Attention will now turn to the Bank of England and the US Federal Reserve.

“The European Central Bank (ECB) has become the most significant central bank to start cutting interest rates, ahead of the US Fed and UK’s Bank of England,” says Ben Laidler, global market strategist for eToro.

“It’s a no-turning-back moment for the global rate-cutting cycle and especially important to supporting the burgeoning European economic and stock market recoveries.

“The $19 trillion European Union economy is the world’s second largest and the biggest to join the global interest rate-cutting path as inflation has cooled.”

Why did the ECB cut interest rates?

ECB policymakers said underlying inflation has eased, “reinforcing the signs that price pressures have weakened”. It said monetary policy has kept financing conditions restrictive, dampening demand and bringing inflation down.

However, the ECB said domestic price pressures remain strong as wage growth is elevated and it expects inflation is likely to stay above target well into next year.

It expects inflation to be at 2.8% this year and pushed up expectations for 2025 from 2% to 2.2%, meaning further rate cuts could be limited

“The [ECB’s] statement refrained from pre-committing to any future cuts and maintained a data-dependent stance,” says Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International.

“Recent upside surprises on wages and inflation are likely to keep the council members on the cautious side.

“As such, a July cut looks clearly off the table. The rate trajectory of the ECB will depend on the evolution of data from here on and the Fed, which we think will be unable to cut this year given the stickiness in US inflation."

When will the Bank of England cut interest rates?

The ECB cut may put pressure on the Bank of England to follow suit.

The next monetary policy committee (MPC) meeting is on 20 June and there are factors that could encourage rates to be cut from their 16-year high.

The rate of inflation has been getting closer to the 2% target while the latest Purchasing Managers' Index hit a six-month low in April, suggesting the restrictive policy is doing its job.

However, wage growth remains high and the Bank of England may want to avoid a June cut due to the general election on 4 July and the risk that the move looks politicised.

This could make a rate cut more likely in the next MPC meeting on 1 August.

The risk is moving too early though before inflation has settled.

Ben Nichols, interim managing director at Raw Capital Partners, says: “The outlook for energy prices is unreliable and geopolitical conflict in Europe and the Middle East could create major challenges further down the line.”

The eurozone “is on the brink of recession”, says Szu Ping Chan in The Telegraph. Output in the single-currency area shrank by 0.1% in the three months to the end of September, the first contraction since the 2020 lockdowns. Another fall in the current quarter would meet the technical definition of a recession – two consecutive quarters of shrinking GDP. 

The “good news” is that the eurozone is “set to avoid a deep contraction”, says Balazs Koranyi for Reuters. The overwhelming sense is more of stagnation than a big recession. But that is cold comfort when growth catalysts are so hard to see. Europe has been hit hard by the energy price spike that followed Russia’s invasion of Ukraine, says Paul Hannon in The Wall Street Journal. 

There has also been a post-pandemic slump in international trade, dealing a particular blow to Germany’s export-oriented manufacturers. On an annualised basis, eurozone GDP fell by 0.4% in the third quarter, even as US GDP soared by 4.9% in the same period.

Stronger US growth partly reflects greater government profligacy, say Valentina Romei and Colby Smith in the Financial Times. Washington ran a primary budget deficit of 9.4% of GDP in 2021, “more than double the level of the eurozone”. US households are thus splurging on the national credit card. But America also enjoys structural advantages as the world economy becomes ever more technology-dominated. There are no European equivalents of giants such as Amazon and Google. That didn’t matter so long as China kept buying German cars and Italian machinery. Germany was “a massive winner [from] globalisation the way it existed until 2018, but that type of globalisation now seems to be over”, says Christian Keller of Barclays Investment Bank. Protectionism is rising and China has established a lead in the electric-car industry.

Southern Europe outperforms the north

The pan-European Stoxx Europe 600 index enjoyed a strong start to the year as the continent escaped a widely feared energy crunch last winter. It is still up by 6.5% in 2023 but has gone nowhere since July as the German economy stumbles and the luxury boom that had propelled Parisian stocks cools.

This year has turned out to be better in Milan and Madrid than in Frankfurt and Paris, says Bastien Bouchaud in Les Echos. Shares in Italian banking giant Unicredit have gained 84% in 2023, with Spain’s Banco Santander up by 32%. 

Italian and Spanish banks have been boosted by rising interest rates and unexpectedly strong growth. Italy’s GDP has risen by 3.3% since late 2019 and Spain’s by 2.2%. By contrast, Germany has grown just 0.3% in that time. After being lectured endlessly by German politicians during the euro crisis, southern Europe is finally enjoying a degree of “revenge”.

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Over the last few weeks, the outlook for many French companies has deteriorated dramatically. The Altice empire, put together by billionaire Patrick Drahi, is in big trouble, ensnared in a corruption scandal, and raising emergency cash to stay afloat. Among other assets, its 24.5% stake in BT may have to be sold off, and its shares are down by almost 60% over the past year.

Last week, shares in Worldline, the payments firm that is one of the biggest tech businesses in France, crashed by 60% as it warned about its profits for the year ahead. One of the country’s few high-tech champions, even if it dates back to the 1970s, is failing badly. 

It’s not looking much better at the drinks giant Rémy Cointreau. Over the last few months, its shares have slumped to their lowest level in 15 years due to poor sales amid a slowing global economy. Meanwhile, luxury goods empire LVMH is on the slide, with its shares down by a quarter in the last six months as demand from China slips. 

France has been riding an artificial boom
Add it all up and one thing is clear. France is starting to get into trouble and the Emmanuel Macron bubble has started to burst. In the six years that he has now been in power, the hyper-energetic French president has benefited from an artificial boom. France rode the rapid expansion of the Chinese economy better than any other major country. Sure, the Chinese bought some German cars and machine tools, but what its nouveau-riche entrepreneurs really wanted was high-status European luxury goods that allowed them to show off how rich they had become.

It was demand from Asia that made LVMH the largest company in Europe and also powered the likes of Hermès and L’Oréal. That generated vast profits, which in turn produced plenty of corporation tax: the state’s tax from companies rose by almost 50% over the last decade. But as China slows down, profits certainly won’t keep on growing the way they did and those tax revenues will dry up. 

Meanwhile, membership of the euro, and the backing of the European Central Bank as it printed vast quantities of new money, has allowed France to run up huge debts. When the euro was launched, France’s debt was just 59% of GDP. It is now up to 112%. That worked while interest rates were close to zero, and when the ECB was buying bonds. Investors have simply assumed that France is “too big to fail” within the eurozone and that in a crisis the other member countries will always bail it out, and so will the central bank. Even so, it has now reached the limit of borrowing. Its credit rating has been cut. The IMF is warning that spending needs to be reduced further. Bond yields are rising. If there is a loss of confidence there could be a rapid exit. 

Macron's close allies' companies start to unravel
Finally, a select group of tycoons close to the president, such as Drahi, built up debt-fuelled empires that are now starting to unravel. They created an illusion of a dynamic, fast-growing France. But companies that are based on borrowing cheap money are rarely solid. If a few of these close allies crash, it will be hard for the president to escape some of the blame. 

Macron has sold himself to the world as a radical reformer. He was the man who would modernise France. True, he has made more progress on shaking up its rigid labour market and burdensome welfare system than his last two predecessors put together. Still, progress has been very slow, and all the grand talk of change has disguised the fact that he has presided over a vast increase in debt and state spending, helped by the luck of a luxury boom and low interest rates. 

Through all of this, France remained stuck in a low-growth rut, with little sign of new industries emerging, and only modest reductions in a punishing level of unemployment. The luck has now run out. Money will be very tight over the next few years. With all his political capital burned up on a tweak to the pension laws, Macron has no space for any further reforms. Soon, it will be clear that the bust has arrived – and the French economy will get very messy.

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Eurozone inflation jumped to a record high of 10.7% in October, outpacing analysts’ projections for an increase of 10.2% for the month. We explain what this means for your finances.

Like the UK, the EU is suffering from high energy and food prices following Russia’s invasion of Ukraine earlier in the year, which are pushing up prices of goods and services across the board.

Inflation in the UK hit 10.1% in September, rising back into double digits after a slight dip to 9.9% in August.

UK inflation figures for October have not yet been published. Nevertheless, they are widely expected to show inflation accelerating again following the increase in the energy price cap.

What is the European Central Bank doing to control Eurozone inflation?

Double-digit inflation is putting a lot of pressure on the European Central Bank (ECB) to continue increasing interest rates.

Here in the UK, the Bank of England has been acting aggressively to raise rates in an attempt to drive down inflation. However, across the Channel, the ECB is having to be more cautious.

The EU is in an incredibly precarious economic position and the central bank is wary of going too far too fast.

But despite these concerns, the ECB has raised its leading interest rate from below 0 to 1.5%. It is expected the bank will unveil another 0.75% hike in December, taking the base rate to 2.25%.

Some analysts believe this could tip the Eurozone into a recession. A recession in the EU would ultimately be bad news for the UK economy as lower demand will have an impact on imports and exports.

A recession may also hurt the value of the euro. This may make it cheaper for holidaymakers and importers, which could be a silver lining.

Will Eurozone inflation have an impact on UK inflation?

Higher inflation in the Eurozone is hardly good news for investors and consumers here in the UK.

It could be seen as a sign of things to come as higher energy and food prices are responsible for most of the increase.

Energy prices across the Eurozone rose by 41.9% in October, from 40.7% the previous month. Meanwhile, the prices of food, alcohol and tobacco rose by 13.1%, up from 11.8% in September,

More worryingly, core inflation, which excludes volatile energy and food prices, rose 5%, up from 4.8% in September. This number suggests that inflation is becoming more entrenched in the economy and is going to become much harder to contain.

What does higher Eurozone inflation mean for you?

Higher Eurozone inflation will ultimately lead to higher interest rates in the rest of Europe. Rising prices may also force the Bank of England to go further with its planned rate rises.

This will be good news for savers who will be earning more money on their cash. However, it will be bad news for borrowers as higher interest rates will increase the cost of borrowing.

If interest rates settle at a higher level here in the UK than in the Eurozone, the pound could strengthen in value against the euro.

That means holidaymakers may be able to get more for their money when travelling to the EU.

A stronger pound may also help reduce inflation here in the UK.

Unfortunately, rising prices across the EU may not mean much for most people in the UK, but it is going to have an effect here.

The EU is the UK’s biggest trading partner and higher prices will feed into exports from the region. That might mean higher prices for consumers here in the UK. With wages already lagging behind inflation, it seems negative real wage growth is going to continue.

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Germany’s economy stagnated in the second quarter, even as eurozone neighbours Spain, Italy and France all registered growth. Retail sales recorded their largest annual fall since 1994 in June, while gauges of business and consumer confidence are at their lowest levels in more than two years. Even Germany’s much-vaunted trade surplus has evaporated, with soaring prices for energy imports seeing it record a €1bn deficit on a seasonally adjusted basis in May. That is its first trade deficit since 1991.

What’s the problem?

Complacency. Germany is a wealthy country – GDP per capita is $50,802 compared with $47,334 in the UK – and has maintained its manufacturing base, with industry accounting for 27% of GDP (in Britain and France the figure is 17%). That has enabled companies to cash in on booming Chinese demand for machines and high-end cars since the latter joined the World Trade Organization in 2001.

Other countries have often been keen to emulate Germany, with many admiring its robust vocational education system, for instance. Yet the resulting sense that all is well has prevented overdue reforms. A moralising obsession with balanced budgets has seen road and digital infrastructure fall behind.

What about energy?

Berlin spent nearly €202bn between 2013 and 2020 on renewable-energy projects, part of its ambitious “Energiewende” (energy transition), says Lea Booth for Quillette. That investment has taken solar and wind’s share of electricity production from 8% to 31% since 2010. The trouble is that the transition has been linked to a catastrophic decision to phase out nuclear power plants – the last are due to shut by December. That has left “the world’s pre-eminent renewable energy champion” needing to reopen coal power plants, a “damning policy failure”.

Now add to the mix naivety about Moscow’s imperialist ambitions: 55% of German gas came from Russia prior to the Ukraine war. With Russia continuing to cut deliveries – the Nord Stream pipeline is currently running at just 20% capacity – Germans are facing a chilly winter.

Will there be energy rationing?

Quite possibly. The federal energy regulator’s “latest scenarios predict that gas will completely or nearly run out by early 2023”, notes The Economist. While households would be prioritised during rationing, industries such as chemicals could grind to a halt. That would send another wave of chaos through global supply chains.

There is already a drive to limit municipal energy consumption as the nation dashes to fill its gas storage to 95% of capacity by November (it is currently at 68%). Hanover has switched off hot water in public buildings; early last month a senator in the state of Hamburg said the city could ration hot water for private households if the gas shortage becomes acute. “The International Monetary Fund estimates that Germany is at risk of losing 4.8% of economic output if Russia halts gas supplies,” say Vanessa Dezem, William Wilkes and Arne Delfs on Bloomberg.

What about German businesses?

They have fallen victim to complacency, too. “In the last ten years, two companies in the DAX… have experienced colossal implosions, caused by fraud,” says John Lanchester in the London Review of Books. First there was the Volkswagen diesel-emissions scandal, which revealed a “contemptuous indifference” towards customers and regulators.

Then in 2019 payments star Wirecard was revealed to have cooked the books. When the Financial Times broke the story, BaFin, the local financial regulator, didn’t just ignore the evidence, it opened an investigation into the whistle blowers, suspecting “market manipulation”. Local banks and regulators closed ranks against trouble caused by “Anglo-Saxon” outsiders.

What else lies ahead for Germany Inc.?

The era of cheap gas is over. As Javier Blas notes on Bloomberg, prices look likely to stay elevated into at least 2024. That could force some energy-intensive industries to relocate. Germany is also trapped by a second “fatal dependency”, says Diana Choyleva of Enodo Economics in Nikkei Asia. “For almost two decades, the synergy between China and Germany” has married cheap production costs with Germany’s “technical know-how and the fruits of decades of engineering breakthroughs”. It has been profitable for German business, but the partnership is now “in its death throes” as China develops its own world leaders. A decade ago, “the sudden emergence of Chinese competitors wiped out Germany’s advanced solar-power industry”. The car industry may be next.

German industry is also hampered by the country’s sluggish moves to adopt new digital tools: “Whether it’s a lack of [mobile phone] service even in the middle of cities, fax machines in doctors’ offices, or a dearth of official services available online, [it is clear] that Germany is stuck in the technological past,” says Elizabeth Schumacher for Deutsche Welle.

Can Germany turn things around?

Germany has been here before. In the 1990s and early 2000s a post-reunification hangover saw it branded the “sick man of Europe”. As Christian Dustmann, Bernd Fitzenberger, Uta Schönberg and Alexandra Spitz-Oener note in the Journal of Economic Perspectives, growth was sluggish and unemployment hit 11.1% in 2005. What changed the picture were the 2003-2005 Hartz labour-market reforms. The resulting “jobs miracle” helped the German economy come through the Great Recession and the eurozone crisis relatively unscathed.

The country’s blandly centrist, consensus-based political system can take time to arrive at the right answers, but it has shown the capacity to get there eventually in the past. With war raging in Europe, Germany’s leaders need to get a grip again.

“Europe once again stands at the edge of the precipice, staring into the abyss below,” says Jeremy Warner in The Telegraph. The 2009-2012 eurozone crisis was centred on “tiny” Greece – just think what debt problems in a major economy such as France could do to the single currency.

French prime minister Michel Barnier’s three-month-old minority government has collapsed after being ousted in a vote of no-confidence on 4 December, following which Barnier resigned. Barnier’s “fragile” administration had been trying to close a fiscal deficit of 6.1% of GDP with €60billion in spending cuts and tax hikes, says Liz Alderman in The New York Times.

His plans have drawn the ire of opposition parties, with the far-left and far-right ganging up to vote him down. That leaves president Emmanuel Macron in a bind. France’s legislature is hopelessly divided, and Macron legally can’t call fresh parliamentary elections until June next year. The risk premium, or “spread”, between benchmark French and German government bonds has touched 90 basis points, the highest level in 12 years. In a further humiliation, financial markets have started charging France the same amount as Greece to borrow for a decade.

Talk of a Greek-style crisis is “for the moment... a complete exaggeration”, Éric Heyer of Sciences Po tells the Financial Times. At 2.9%, French ten-year yields are far below the 16% level that Greek bonds hit in 2011. Indeed, French borrowing costs are currently lower than Britain’s. Unlike with Greece, there is no doubt that European institutions will do “whatever it takes” to save France, says Andrew Kenningham of Capital Economics. Crisis-era Greece had a 15% deficit and plunging GDP, compared with a 6% deficit and modest growth in France today. Paris requires a relatively small fiscal tightening to sort out its budget. The problem is not so much economic as political – France seems “unable to give any government a mandate for deficit reduction”, leaving the issue of growing debt to fester.

The real risk for the eurozone will only come if Marine Le Pen’s far-right party takes power in a future election. While Le Pen no longer supports leaving the euro, her party will be “much less committed to cooperating with the EU” to keep the currency bloc functioning smoothly. If things do get out of hand, then expect the European Central Bank (ECB) to deploy its Transmission Protection Instrument (TPI), says Johanna Treeck in Politico. The TPI allows the ECB to buy up government bonds if it thinks bond markets have become “disorderly”. Yet the “bar for such intervention is high” – probably requiring French debt to hit somewhere above 200 basis points of spread over German bunds, compared with today’s 85 points.

What the crisis in France means for Macron

Macron has pledged to appoint a new prime minister within days and vows to stay in office until the end of his term in 2027. Macron has three bad options to resolve the political deadlock, says Pierre Briançon for Breakingviews. He could try to repeat the failed Barnier trick, appointing a “temperate centrist” willing to do budget deals with the far-left or far-right. Alternatively, he could pick a far-left or far-right administration, purely to demonstrate that the populists are also “unable to govern”. Finally, he could conclude that he himself is the problem and resign, plunging France into the uncertainty of a snap presidential election.

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MoneyWeek has been around long enough to see several big trends recur. Most of them have been fascinating to cover. But one key theme of the past decade fills me with dread, because it was like watching a slow-motion car crash: the euro crisis. It may now be making a comeback.

The launch of the euro coincided with the start of a global upswing, so the currency’s intrinsic flaws were overlooked. Everyone was getting used to the conversion rates (an irksome 13.76 schillings to one euro in Austria). Because the eurozone encompassed most EU members it was trumpeted as a giant leap forward for European integration.

A sub-optimal currency area

Many analysts, however, pointed out that there had never been a successful single currency without a single government, and that the euro was far from what economists call an optimal currency area. The basic idea is that groups of structurally similar economies, who often tend to experience similar business cycles, are best suited to sharing a currency. A similar approach to money management helps too, as it pre-empts fights about any joint budgets and potential debt issuance.

Benelux, Germany and Austria would arguably be an optimal currency zone: wealthy manufacturing-based economies with a shared instinct for sound money. What we got instead, of course, was northern Europe plus the inflation-prone south’s less healthy balance sheets. The prospect of sharing a currency with people who can’t budget, and would probably need a bailout at some stage, unnerved many northern Europeans, but such objections were steamrollered by the integrationist tide.

When the financial tide went out after the crisis, investors’ fears over the sustainability of the southern countries’ debt duly proved justified and bond yields soared. Since bond yields are implied long-term interest rates, that exacerbated countries’ solvency problems.

In the absence of a central fiscal authority to send money to poorer parts of the currency area to temper the impact of a downturn, only painful reforms and a clampdown on prices and wages would restore competitiveness and fuel confidence in stricken states’ ability to grow out of debt.

Cue endless wrangling between the European authorities and southern governments, and a cascade of market panic attacks focused on different countries until ten years ago this week Mario Draghi promised to do “whatever it takes” to keep southern bond yields low. The prospect of the European Central Bank hoovering up enough bonds to keep the yields down kept the wolf from the door, and a similar mechanism, the Transmission Protection Instrument, was launched last week, again against a backdrop of turmoil in Italy.

The wolf is still there, however. There is still ample scope for market panics and political clashes between Brussels and the member states, while the EU’s construction of a fiscal union (with an incipient banking union and a Covid-19-induced recovery facility allowing the EU to borrow collectively) is proceeding at the speed of a hungover giant sloth. More broadly, the eurozone is still stuck with a structure that acts as a deflationary straitjacket for much of the south, a recipe for recession and rancour. Until there is a European government or the euro is dismantled, the eternal crisis can only be managed or fudged – never resolved.

The eurozone is fighting “fires on all fronts”, says Mehreen Khan in The Times. Squabbling in Italy’s governing coalition has left the bloc’s third-biggest economy heading for “a summer of political paralysis”, with the future of prime minister Mario Draghi in doubt.

Between record energy prices, the threat of Russian gas being switched off and the prospect of recession in Germany, policymakers in Brussels and Frankfurt already had enough to deal with.

European governments have begun to work under the assumption that Russian energy will be cut off entirely this year, say Ewa Krukowska and John Ainger on Bloomberg. The European Commission is reportedly preparing a plan for “a voluntary 15% cut in natural gas use by member states starting next month” to conserve stocks for winter. The Commission thinks a Russian gas cut-off and a harsh winter could wipe 1.5% off EU GDP.

Germany has reduced its dependence on Russian gas from 55% to 35% since the invasion of Ukraine, says Philip Oltermann in The Guardian, but that still leaves it heavily exposed to Putin’s whims. For now, politicians hope to spare households from rationing while imposing restrictions on industry, which accounts for roughly one-third of gas use. Yet the chemical and pharmaceutical industries are warning of unintended “domino effects” from more supply-chain disruption.

“The good news is that the EU’s tanks are now almost 60% full”, more than this time last year, Leslie Palti-Guzman of data firm Leviaton told The Economist. Europe has also become a major importer of liquefied natural gas (LNG), with imports up 70% year on year in the first quarter. “To the chagrin of greens” European governments are also granting waivers for “filthy coal” plants to “crank out more power”.

The eurozone sovereign debt crisis came hot on the heels of the 2008 financial crisis.

The main focus throughout was Greece. That’s where it kicked off, when an incoming Greek government revealed that the national balance sheet was in a much worse condition than anyone had thought.

To cut a long (and pretty boring) story short, the headline struggle during the eurozone crisis was “who carries the can for Greece’s inability to repay its sovereign debt?”

If the eurozone had been the US – with not just shared monetary policy, but also shared debt issuance and fiscal policy – the problem could have been solved easily. In effect, Greek debt would have been backed not just by Greek taxpayers, but also by the European Central Bank and the rest of the eurozone’s taxpayers.

But that’s not the way the eurozone worked (and still doesn’t). German taxpayers specifically were not keen to be on the hook for Greek debts.

So the answer largely ended up being a) Greek bondholders, who saw the value of their debt written down; and b) the Greek population, who endured a severe depression as Greece – under the duress of the single currency – deflated its way back to something approaching solvency.

How financial contagion nearly shattered the euro

So that’s the headline story. But during this whole process there was a much bigger underlying concern. That was the fear of “contagion”.

At the end of the day – although it took the eurozone authorities a long time to come to the conclusion – Greece was sufficiently small that it could have left (or been ejected from) the eurozone, without jeopardising the survival of the single currency.

By contrast, there were plenty of other countries with messy balance sheets too. And markets weren’t slow to pick up on this.

Investors had spent most of the early years of the eurozone (ie, the 2000s) driving bond yields closer across the region. The assumption was that the euro was just the start. Countries that shared monetary policy would eventually have to share fiscal policy too. So a Greek bond was just as good as a German bond, because they were all backed by the same thing.

That assumption was shattered by the Greek debt crisis. As a result, investors started to differentiate between eurozone countries. Bond “spreads” – that is, the gap between “safe” German debt and higher-risk countries – blew out. In other words, countries with the worst balance sheets saw their cost of borrowing rise.

The “peripheral” countries included, alongside Greece, Portugal, Ireland, Spain and Italy. Portugal and Ireland, being relatively small nations, basically knuckled under and imposed similar sorts of austerity packages to Greece. Spain’s finances were in fact not that bad - its main problem was a massive housing bubble.

But Italy – Italy was a problem. A sclerotic economy plus a heavily-indebted balance sheet. Moreover, it was too big to push around. Imposing a depression on Greece was possible. Not so Italy, one of the founding member states.

Faced with the risk that some countries, and Italy specifically, would in effect be locked out of borrowing in sovereign debt markets, the eurozone had to take action. That’s where Mario Draghi, then head of the European Central Bank (ECB) came in. In 2012, he said he would do “whatever it takes” to save the euro.

In the end, that eventually added up to an open-ended commitment to buy the sovereign debt of the most troubled countries, which would in turn keep spreads from exploding, and allow troubled countries to continue borrowing.

It worked. Contagion was halted. Greece continued to cause the odd spasm of fear, but with the risk contained to Greece itself, wider markets calmed down.

Italian political strife is rearing its head again

For a while, the fundamental problems of the eurozone faded into the background. The Brexit vote almost certainly helped – it’s always good for cohesion to have something to triangulate against.

But more important was the ongoing deflationary backdrop. High interest rates were not going to be a problem and central bank intervention was regarded as standard for most major economies.

Finally, Draghi – the saviour of the eurozone – went from being the head of the ECB to being the Italian prime minister.

But now everything is changing. And suddenly, existential fears about the eurozone are erupting again.

Firstly, inflation is back. That means interest rates can’t stay where they are. And put simply, if borrowing costs generally are going up, and the ECB is no longer printing money to funnel into the countries whose bonds are viewed as most risky, then spreads are going to start blowing out again.

Secondly, Italian political turmoil is raising its head again. During the Greek crisis years, the big bugbear was a left-wing populist party called Five Star. Now the most popular contingent in the country is a right-wing populist movement comprising three different parties, including one led by Silvio Berlusconi.

Now I’m no expert on Italian politics and given that I’m in my late 40s, I’m not sure there are sufficient years left to become one. But the upshot is that Draghi may end up resigning and that could result in elections, and while the various members of any prospective governing coalition have backed away from actively campaigning to leave the eurozone, they all have eurosceptic backgrounds.

How will the ECB stop the eurozone from cracking up this time?

So what’s the plan?

For now the ECB is going to keep raising interest rates. But it also intends to unveil an “anti-fragmentation tool” on Thursday. The purpose of this tool – whatever shape it arrives in–- will be to give the ECB a licence to tie eurozone bond yields together.

The problem is, they can’t be as overt as that when they unveil it. The lack of overall political unity means that the ECB faces very similar problems to during the Greek crisis.

Back then, they couldn’t bail Greece out because of the idea that it would incentivise “bad” behaviour on the part of Greece – in effect, you’re penalising German taxpayers with more inflationary monetary policy so that Greece doesn’t have to embark on much-needed reform (all of this depends on your point of view, to be clear, it’s not black and white – but that’s the nature of the argument).

So now they can’t say: “we want Italy to be able to borrow at a minimal premium to Germany” because that then looks like running profligate monetary policy in order to allow Italy (or any other country that ends up needing it) to duck reform.

In other words, it’s all a bit messy in the eurozone again, and we’re back here for the same reason as before: you can’t have a fully functional monetary union without having a political union too.

What happens next? I used to think the eurozone was inevitably doomed long-term. I’m not so sure about that now. For the euro to crack up, a member state (and one of the big ones) needs to pull out. That boils down to politics – you need a political party to argue the case, and people to vote for it.

The only country where that seems potentially possible is Germany, in that Germany may end up getting fed up with feeling like the bag carrier for the rest of the eurozone. But even then, I suspect that there is too much of a sense of obligation for that to happen.

So in the long run, I think the path of least resistance is to lean heavily on the ECB for support during crises; and to gradually introduce some form of common debt instrument (we’re getting there with the coronavirus relief package).

In the meantime, all of this stuff will continue to be a horrendous distraction and more than likely contribute to disappointing growth in the region. But individual companies will do fine.

Given that eurozone equities are among the most-hated in the world right now, I’m tempted to start having a look. You might want to do the same.

European Central Bank (ECB) president Christine Lagarde was a synchronised swimmer as a teenager, says Jill Treanor in The Sunday Times. Now, she is “struggling to keep her head above water” as the eurozone’s periphery feels the pressure from tighter monetary policy and Italian and Spanish bond yields soar to eight-year highs.

Last week, the spread between German and Italian ten-year government bond yields spiked to 250 basis points (2.5%). That is well short of the 500-plus basis points that it reached at the height of the 2011-2012 eurozone debt crisis, but it was enough to force the ECB’s governing council to assemble for an emergency meeting in Frankfurt.

The central bankers unveiled a new “anti-fragmentation tool”. The suggestion that the ECB will act to keep spreads down “buys time”, Silvia Merler of Algebris Investments tells the Financial Times. But with details still scarce, it “does not take them out of the corner yet”.

Italy’s debt challenge

Italy – whose €2.759trn stock of debt is worth almost 150% of GDP – is the key concern, says Jérôme Gautheret in Le Monde. A debt crisis in the eurozone’s third-largest economy would pose an existential risk to the single currency.

The spike in yields leaves the Italian treasury paying interest rates of roughly 4%. For now Rome is maintaining the confidence of markets, thanks to the leadership of its prime minister, Mario Draghi, Lagarde’s predecessor at the ECB. Yet his “grand coalition” government “is showing increasingly obvious signs of running out of steam” ahead of elections due next year. “The personal aura of ‘Super Mario’ may no longer be of great help in protecting Italy from market storms.”

Comparisons with the eurozone debt crisis are overdone, say Martin Arnold and Amy Kazmin in the Financial Times. Things have changed over the past decade. Italy stands to receive €200bn in grants and cheap loans from the EU’s post-pandemic recovery fund. That will provide an economic boost worth 12.5% of GDP over five years. That help is tied to structural reforms that might drag Italy out of its long economic stagnation. The ECB also has a clearer plan for how to fight eurozone break-up risks – something it sorely lacked in 2011.

Still, the ECB’s recent behaviour doesn’t inspire much confidence, says Jeremy Warner in The Daily Telegraph. Why it is still persisting with asset purchases and negative interest rates when inflation is at 8% “is anyone’s guess”. Perhaps it is because while other central banks can just balance between the twin threats of inflation and stagnation, the ECB must also try to hold the euro together. “Europe’s monetary union is a bit like a bumblebee; aerodynamically it shouldn’t fly, yet somehow it does. For how much longer must again be in doubt.”

“The eurozone is on the brink of stagflation,” says Eric Albert in Le Monde. Annual inflation hit 8.1% last month, a level unprecedented since the creation of the single currency. Energy prices, which rose at an annual rate of 39% in the past year, were the main cause, but “gradually the phenomenon is spreading to the entire economy”. At the same time, growth was just 0.3% in the first quarter. Industry is holding up reasonably well for now, but households are being “strangled by the sudden rise in the cost of living”.

Few economists “expect an outright recession” in the year ahead, says The Economist. “Many services firms are still reaping the rewards from reopening,” especially in the euro area’s tourism-reliant south. A cushion of pandemic savings and “plentiful” jobs should provide a backstop for consumer confidence. Yet the European Central Bank (ECB) finds itself in the tricky position of balancing soaring energy prices and a weaker growth outlook. In America loose government spending has contributed to rocketing inflation, but Europe’s price rises come mainly from the supply side, which a central bank can do little to control.

This week the ECB was poised to announce that it will stop buying bonds imminently. That should pave the way for interest-rate rises next month, say Dhara Ranasinghe, Tommy Wilkes and Saikat Chatterjee for Reuters. The bank’s deposit rate is currently at -0.5% and hasn’t been raised since 2011. There is growing speculation that policymakers might even opt for a 50-basis point rise (rather than the expected 25-point rise) to get inflation under control.

Earnings can’t beat the gloom

The pan-European Stoxx 600 index is down more than 9% since the start of the year. Even so, corporate earnings have been robust, says Ian Johnston in the Financial Times. “Earnings per share grew by 42% for the 452 companies in Europe’s Stoxx 600 share index that reported first-quarter numbers,” compared with 9% for US stocks. About half of European blue-chip earnings come from outside Europe, so the weak euro is also juicing earnings.

Strong earnings have been powered by the commodity-price boom, says Société Générale. Commodity-linked sectors account “for close to 10% of the market capitalisation in Europe, but almost 20% of total earnings”. As of the end of April, the Stoxx 600 was trading at a forward price/earnings (p/e) ratio of 13.1, below historical averages. Yet that discount comes from historically low valuations for commodity firms. “Looking at the Stoxx 600 excluding commodity-linked sectors… the forward p/e is at 14.5 times, so still above the ten-year and 20-year historical averages.”

Still, on a long view, it might pay to look at Europe’s smaller stocks, says Ollie Beckett of Janus Henderson. European small caps returned 301% in the decade to the end of 2021, compared with 194% for large firms. “The European economy has been criticised for being sluggish, but the universe of smaller companies continues to produce dynamic and innovative businesses that are well-placed to benefit from… factors such as the energy transition, or the changing healthcare landscape.”

Even by the standards of the American justice system, it was a huge settlement. Earlier this month, the German insurance giant Allianz agreed to pay $6bn in fines to settle claims that its US investment arm cost investors billions of dollars by misleading them about the risks of some of its funds. It was a significant enough story in itself, and one that will have implications for the rest of the finance industry. But it was also far from the first major German company to be caught out in a scandal. There is something rotten at the heart of Germany – and that is becoming more obvious all the time.

Take the technology company Wirecard, for example. It was worth €24bn at its peak, and was feted as one of the fastest growing companies in Europe. But it collapsed into insolvency in 2019 after a series of accounting irregularities were exposed, and its chief executive was arrested. Shareholders lost all their money in what was, without question, the worst corporate collapse of the last decade.

Before that, Volkswagen, which vied with Toyota as the largest automotive company in the world, was exposed as having systematically cheated on emissions standards for its cars, pretending they met environmental rules when in fact they didn’t. Back in 2016, Deutsche Bank was fined $7bn in the US for mis-selling mortgage securities, while in the last few years it has been fined for Russian money laundering, the Libor interest rate scam, a violation of US economic sanctions, as well as admitting it hired private detectives to spy on its critics. It is hardly a great record for what is meant to be the country’s most prestigious financial institution.

Of course, every country has some rogues and bad apples. There are plenty in Britain, and in the US as well. And yet, there can be no question that over the past decade if there is a major corporate scandal it has “Made in Germany” stamped all over it. In reality, this week’s revelations at Allianz should be no real surprise.

Three causes of corruption

There are three reasons why German business has become so endemically corrupt. First, it has a cosy, corporatist system that protects insiders. The country gets a lot of praise for a system that enables companies, unions, and the government to work by consensus. That has some strengths. It has allowed the German economy to plan for the long term, to build up skills and expertise, and to concentrate on dominating key export markets. It has helped build the trade surplus and minimise labour disputes. However, it also has a big weakness. It protects people, and stops hard questions being asked. And it allows cronies to stay in position far longer than they should.

Next, Germany has a weak stockmarket that makes takeovers virtually impossible. There have been a few, such as Vodafone’s takeover of Mannesman two decades ago, but they are very rare. Shareholders don’t typically support them, and neither do the regulators, while the government has recently stepped up scrutiny of foreign bids. Again, being safe from hostile acquirers might allow companies to plan for the long term. But it also means there is very little scrutiny of management, nor any real consequences if things go wrong.

Finally, there is a culture of complacency that comes from having an undervalued currency. The euro is worth far less than the deutschmark would have been, and that makes it relatively easy for German companies to keep the export machine running and make big profits. Mediocre management teams can stay in place for far longer than they should.

We are often told that Germany’s economy is a model that should be emulated. It’s true it has some great companies, many strengths, and it is a wealthy economy, even if there is not much sign of any new industries emerging. But one point is also becoming painfully clear.

It is also the most corrupt in the developed world, and that is getting more and more evident all the time. And that is surely not something that should be admired or respected – and certainly not copied.

For more on this topic, see:

What exactly is going on in the Wirecard scandal?

On Sunday, France will elect its president for the next five years. It will almost certainly be close. Emmanuel Macron, the centrist incumbent, looks to be slightly ahead of Marine Le Pen, his far-right challenger. Markets will breathe a sigh of relief if he scrapes home. But hold on. In reality, whoever wins, France’s massive debts are starting to pose a systemic risk to the global financial system – and that is not going to go away whoever takes charge of the Élysée Palace next week.

In many respects, Macron has been a decent, if hardly spectacular president. That may have obscured the extent to which France has quietly turned into one of the biggest debtors in the world. Macron may have talked about balancing the books, but under pressure – first from the gilets jaunes protests, which could only be brought under control with higher state spending – and then by the pandemic, he has spent on a vast scale even by the standards of a country where the state already accounted for more than half of GDP. France’s total debts are starting to become frightening. Its debt-to-GDP ratio was under 100% when Macron took office, but it is now more than 115%, far higher than major rivals such as the UK (at 94%) and Germany (a modest 72%).

Not just the pandemic

Some of that is accounted for by emergency measures to cope with the pandemic, and spending will come down as those steadily get wound up. But France also has one of the highest structural deficits in the developed world, estimated at between 3% to 4% of GDP, and attempts to reduce that – for example by reducing state pensions or pushing out retirement ages – are typically met with riots and a government climb down. It is hard to see how the books will ever be balanced again.

Just as alarming as the ratio is the total amount of accumulated debt. France now owes a staggering $3.3trn, and that is expected to rise to close on $4trn by 2027 as the country carries on spending more than it raises in taxes year after year. That is the third largest national debt in the world, after the US and Japan, and even worse it is owed by a country that does not even have control of its own currency. Unlike Japanese debt, or indeed Italian debt, mostly held by domestic investors, France’s is traded widely, with more than half of it held in the rest of the world. In short, financial institutions everywhere are loaded up with French bonds, complacently assuming they are safe forever. But that can hardly be taken for granted.

Delaying the inevitable

It’s true that Le Pen may have ditched her plans to leave the euro and restore the old French franc. That really would have rattled the markets. And yet, there can be no question that she would still be very worrying for the sovereign debt markets. She is running on a populist platform, heavy on spending promises, national sovereignty, and opposition to rule from Brussels. In office, she might well return to the threat to restore the franc, and she would definitely be locked in constant battles with the rest of the EU, much as the Poles and the Hungarians are.

It won’t be that much better if she loses. A re-elected Macron will quickly turn into a lame duck. He has no real party base, no clear successor, he can’t run again in 2027, and at best he probably has limped across the line to victory with a narrow win and not much of a mandate to reform anything. The markets will quite rightly start fretting about what will happen to French politics when he is gone. And by then, of course, the total debt will be even higher.

In reality, anyone holding vast quantities of French government paper will have to take that into account, just as they did for Greek and Italian debt during the eurozone crisis of 2011 and 2012. Any kind of wobble in the French debt market will ripple out around the world very quickly. The political risks around French debt are now a ticking time bomb underneath the global financial system. It is going to blow up one day – and that will be true, whatever the result on Sunday.

What’s happened?

Germany’s new chancellor, Olaf Scholz of the centre-left Social Democrats, was sworn in on Wednesday, heading the first three-way coalition since the 1950s. Scholz’s partners in the coalition are the Free Democrats, a free-market liberal party that for decades has been the go-to coalition partner for the centre-right CDU; and the Greens, who were previously part of an SPD-led coalition under Gerhard Schröder from 1998-2005. The departure of Angela Merkel after 16 years is a moment of change, but also continuity. The SPD has been part of Merkel’s coalition for 12 of her 16 years, and continuously since 2013. It has been in government – either as senior or junior partner – for all but four years since 1998. And Scholz himself has been Merkel’s vice-chancellor and finance minister since 2018, sticking closely to the hawkish fiscal policies of his CDU predecessor, Wolfgang Schäuble, until the pandemic opened the taps. Scholz was previously a labour minister in the first Merkel government, then mayor of Hamburg since 2011.

So not much will change?

Scholz campaigned explicitly as the continuity candidate, claiming that his experience and non-ideological pragmatism made him a natural heir to Merkel. Scholz, as SPD chairman, was a strong supporter of the controversial but crucial labour reforms that paved the ground for Germany’s economic success under Merkel, for example. Scholz will lead a coalition of apparently unlikely bedfellows: the fiscally conservative and business-friendly FDP, whose Christian Lindner is the new finance minister; and the free-spending Greens, who provide the foreign minister, Annalena Baerbock, plus Robert Habeck at the head of a new climate and economy super-ministry. The unexpectedly rapid conclusion of an unlikely coalition may well be testament to Scholz’s low-key consensus-building skills. But governing may require something more.

What’s the plan for government?

The overarching themes are, first, “modernisation” – Scholz plans a “decade of investment” and the “biggest industrial modernisation of Germany in more than 100 years” – and decarbonisation, with a vow to make the country a “pioneer in climate protection”. Specific commitments include a pledge (and specific actions) to end coal-powered electricity by 2030 (eight years earlier than previously planned); to raise the share of renewables to 80% by 2030 (up from a previous goal of 65%); and to establish a carbon price of €60 a tonne. There will also be a big rise in the minimum wage (from €9.60 to €12 an hour), a commitment to “stable” pensions (with no reduction in pensions or pensionable age) and more social housing and spending (such as a “basic income” for children).

What else is planned?

The new government has also pledged to legalise cannabis for adults; remove the concept of “race” from the federal constitution; introduce more generous family-reunification rules for refugees, but make deportations easier; and introduce even tougher rules on video surveillance and data storage. On fiscal policy, it has agreed to reinstate the constitutional debt brake (the cap on new borrowing that was suspended due to the pandemic) in 2023, and committed to creating a state-owned bank to promote green investment and digital transformation. One big challenge will be to find the billions needed to green Germany’s economy and rebuild its infrastructure, while also sticking to the fiscal rules. As such, the appointment of uber-thrifty Lindner as finance minister could be helpful, says The Economist. Scholz has come up with a variety of fiscal wheezes to raise funds without breaking the rules and the presence of Lindner, who is strongly pro-business, will reassure conservatives.

But there will be challenges?

Indeed. The most immediate are dealing with the current wave of coronavirus – Germany’s worst to date in terms of infections, though not deaths – and an economic outlook that has markedly worsened in the weeks since the election in late September. Last week inflation hit 6%, the highest since the early 1990s, and this week data revealed a slump in factory orders far worse than any analyst predicted, due to a fall in export demand. The OECD think-tank has just cut its 2022 growth forecast for Germany by half a point to 4.1%. Some analysts even predict a contraction in GDP in the current fourth quarter, driven by supply-chain disruptions. Industry has been hobbled by shortages of raw materials and key inputs such as microchips, leading to bottlenecks and production problems, particularly in the crucial automotive sector.

The lights will stay on though?

That will be a challenge given the ambitious climate goals, which imply the need to build thousands of wind turbines and solar panels, extensive new electricity grids and a swath of gas-fired power stations, says Guy Chazan in the Financial Times. The most pressing challenge though is what to do about Nord Stream 2. The gas pipeline – which is completed but not yet approved for use by German regulators – will bring Russian gas directly to Germany, bypassing Ukraine and making it easier for Moscow to bully Kyiv. In other words, going ahead with the pipe increases Putin’s leverage and ability to continue its hybrid warfare against Ukraine, a Western ally (see also page 11). This and other foreign-policy and security issues could yet prove the critical faultline in the coalition, says Wolfgang Münchau in The Spectator. The SPD “are perhaps Russia’s most important strategic partner in Europe”. Ex-chancellor Gerhard Schröder is Russian president Vladimir Putin’s “chief international lobbyist”, and the party is pro-Nord Stream 2. The Greens and the FDP are strongly opposed, and a decision can’t be put off forever. “The wedding went as well as can be expected,” says The Economist. “But the honeymoon will be brief.”