Markets have seen heightened volatility this week as a result of uncertainty created by President Trump’s policies on geopolitics and trade, with US equities struggling
It’s been a different story in Europe, where the uncertainty created in Washington is proving to be a catalyst for policy change, and the end of long standing fiscal policies as countries shift towards huge increases in defence spending.
The uncertainty over the transatlantic alliance and the defence of Europe has certainly been the catalyst for rapid shifts in policy, both at the EU and the domestic level. Last week we saw the UK accelerate plans to boost defence spending, but the numbers involved in the UK have been dwarfed by the proposals we have seen announced this week from Germany and from the European Union.
In Germany, the leaders of CDU/CSU and SPD parties that are set to form the new coalition government announced an agreement to approve three changes to the debt brake that will be voted upon before the current session of the Bundestag ends later this month. The vote will take place while the centrist parties still hold a majority large enough to change the constitution. The plan announced on Tuesday includes a €500 billion special purpose vehicle for infrastructure investment over the next decade, an exemption from the debt brake for defence spending above 1% of GDP and an increase in borrowing limits for states from zero to 0.35% of GDP. Prospective Chancellor Fredrich Merz even uttered the famous words “whatever it takes” (© Mario Draghi 2012) and says the intention is to “re-arm completely”. These comments were in reference to “threats to freedom and peace” in Europe. Defence could rise to 3% of GDP as soon as next year. This is a huge shift in mindset from the mainstream German parties that have been anchored to the debt brake since the global financial crisis, and a recognition that not only does Germany need to step up in terms of defence spending, but also the country needs to rebuild its economic infrastructure after decades of underinvestment.
At the EU level, Commission President Ursula von der Leyen put forward a “ReArm Europe” proposal to the EU leaders meeting in Brussels yesterday to loosen fiscal rules specifically to allow significantly higher defence spending that could allow as much as €650 billion in addition spending over the next four years. In addition, a €150 billion loan facility will be made available to support joint defence procurement, and the European Investment Bank will be given more flexibility to lend to governments for defence spending. The plan could mobilise around €800 billion in funding with the EU guiding towards defence spending moving towards 3.5% of GDP in 2028.
These numbers are very significant and highlight how Europe’s leadership has recognised that we are seeing huge geopolitical shifts as a result of the Trump administration and are beginning to act. The likely new German government has certainly hit the ground running, even as the coalition is yet to be formally agreed.
We have seen plenty of news on tariffs as financial markets have had to adjust to the fact that President Trumps threats on tariffs on the US’s closest trading partners, long seen as a tool for negotiation, became reality earlier this week, for 24 hours anyway. The new tariffs increased the tariff on Chinese imports to 20% and initially placed 25% duties on almost all Mexican and Canadian imports. Subsequently, the auto sector, and all goods compliant with the USMCA trade deal, were exempted from the tariffs, but only until the start of April. The policy moves come with a high degree of uncertainty but heighten the risks of a ‘trade war’, presenting downside risks to growth and upside risks to inflation.
The tariffs cover around $1.5 trillion of imported goods in total and have the scope to push both Canada and Mexico into recession if they are fully implemented and sustained, given how much of their respective economies are reliant on the US as their primary trading partner. Exports to the US make of 77% of all Canada’s exports equal to 21% of Canada’s GDP. For Mexico, exports to the US are 79% of all exports, equal to 27% of GDP. The fragility of the USMCA, the “greatest trade deal in history” per President Trump in 2017, is clear. Canada immediately responded, imposing 25% tariffs on $30bn of US imports, with tariffs on a further $125bn of US goods in three weeks’ time.
Mexican President Claudia Sheinbaum will use a speech this weekend to detail her country’s response. In the aftermath of the tariff news, equity markets sold off, including across Europe, which is seen as next in line for Trump’s tariff wrath. Europe’s reliance on the US for trade is much lower than Canada or Mexico, with around 19% of all exports, or 2.9% of GDP heading to the US. All the same, certain sectors, such as auto manufacturers, would suffer significantly under tariffs which now have an increasing sense of inevitability.
Back in the plain vanilla world of central banks and inflation, the European Central Bank cut interest rates by 25 basis points when they met yesterday, taking rates to 2.5%. The move was in line with expectations, as was the accompanying commentary becoming a little more hawkish on the path of rates from here. The policy statement described the policy stance as “meaningfully less restrictive” and ECB President Christine Lagarde noted a pause at the next meeting is an option and removing her comments on a “lower direction of travel” on rates. Lagarde stressed a data-dependent and meeting by meeting policy approach. The next meeting will take place after we have – possibly – some clarity on President Trump’s tariff intentions for the EU, which may give the ECB reason to think differently.
The uncertainty surrounding US trade policies has weighed heavily on assets, not least in the US, where the stock market has now given up all of the post-election gains. Policy announcements in the US remain hard to analyse. Even as the tariff announcements came on Monday, by Tuesday evening it was clear that the headline 25% rate would not apply to all sectors. This level of extreme uncertainty is clearly a headwind for consumers, corporates and financial markets. In the midst of the political and geopolitical noise, we are also seeing continued evidence of an economic ‘soft patch’ in the US, which certainly won’t be helped if the nascent ‘trade war’ persists. Meanwhile, European markets, despite some intra-week wobbles, continue on a positive trajectory and the new dynamism we are seeing from both the EU and Germany loosening fiscal constraints is a positive. The US has seen many years of strong growth fuelled by an ever-growing deficit while Europe, fiscally constrained, looked on in envy. Maybe, just maybe, the tide is now starting to turn.
Source: Columbia Threadneedle Investments as at 07 March 2025
