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‘It’s a New World’: Fragile Transatlantic Relations Start to Upend Markets
(Bloomberg) -- European markets are coming to grips with a looming era of higher government spending as the transatlantic alliance that’s endured for almost 70 years starts to buckle under the weight of Donald Trump’s shift toward Russia and US protectionism.
Trump’s policies are forcing European nations to embark on the most aggressive increase in defense spending since the Cold War. The result: Bonds from euro-area governments are underperforming US peers as investors brace for a wall of debt issuance, a gauge of the bloc’s defense stocks has soared to a record high and the the euro is strengthening against the dollar.
Union Bancaire Privée sees the yield on the German 10-year bund rising to 3%, potentially within three to six months, from 2.4% last week. Meanwhile, Deutsche Bank AG has scrapped its long-standing euro short recommendation, dubbing the European fiscal development as “highly significant.”
That’s potentially just the beginning of a wider transformation across asset classes. Even though central bank policy will remain a key driver of prices in the near-term, investors now see a fundamental shift in Europe that will affect portfolio allocations for years to come.
“It’s a new world,” said Gabriele Foa, portfolio manager at Algebris Investments. “The US is signaling appetite to change things from a geopolitical perspective for good.”
In the short term, following Trump’s showdown Friday with Ukrainian President Volodymyr Zelenskiy, attention is trained on Thursday’s European Union defense summit. Leaders are expected to call on the bloc’s executive to kick-start the legislative changes that can unleash billions in defense spending.
That potentially could be paid for with borrowed money, though the bloc may have to fight for buyers for its bonds at a time when government issuance globally is already at a record.
“Germany needs to raise a lot of money — they’re not going to have any choice,” said Peter Kinsella, global head for FX strategy at Union Bancaire Privée. “The EU now has to view the United States as an adversary. It indicates that a lot of the assumptions that we always made about security, about trade, about everything else are now questionable.”
A gauge of the attractiveness of German debt fell to the most negative on record on the prospect of more defense spending.
Many other EU members also have under-invested in security for years. But countries like France and Italy are already shouldering huge debt burdens, putting them in the crosshairs of bond vigilantes — a risk that’s reignited the debate over joint bond issuance, a route the EU embraced during the pandemic five years ago.
Even before Trump returned to the White House, former European Central Bank President Mario Draghi urged the EU in a report to invest as much as €800 billion ($831 billion) extra a year and commit to the regular issuance of common bonds to make the bloc more competitive. He argued a new era of spending was imperative to develop advanced technologies and boost defense and security of critical raw materials.
Little wonder then that in equities, the damage to the transatlantic alliance has made itself felt in shares of defense companies. A basket of European military contractors compiled by Goldman Sachs Group Inc. has surged more than 60% this year to a fresh record high, led by Germany’s Rheinmetall AG.
“You just have to look at the performance of Rheinmetall in Germany; it looks like a tech stock,” said Edmund Shing, chief investment officer at BNP Paribas Wealth Management. “That’s been strong and will continue to be like that because we know European NATO countries are going to have to spend substantially, including now Germany.”
While European stock indexes more broadly are outperforming the US market this year, over the longer term, the prospect of higher bond yields and stronger currencies may serve as a drag on prices.
The euro just a month ago was a whisker away from parity with the dollar, trading almost at $1.02. Now it’s climbed to near $1.05. At the same time, Sweden’s krona surged 1.5% against the dollar on Monday in a bet on European rearmament, outperforming G-10 peers.
Gold’s record-breaking run, too, has been buoyed by investors seeking a haven from the increased geopolitical fragmentation. Amundi, Europe’s biggest asset manager, has been adding exposure to the precious metal and sees it as “a permanent component” of asset allocation, said Monica Defend, head of the Amundi Investment Institute.
A ceasefire in Ukraine would bring a “warlike peace,” according to strategists including Christopher Granville at TS Lombard. It sees further gains for European defense stocks and gold as a result of “Russia being left with the upper hand by an America First Washington.”
--With assistance from Sujata Rao and Margaryta Kirakosian.