A New Fortress Europe: Stronger Defense, Lower Equity Risk

What a week it was…

The US signaled it will no longer be participating in NATO exercises in Europe, in all likelihood in view of a complete withdrawal of US troops from the continent. The US also stopped sharing (“offensive”) intelligence with Ukraine, with the Russian army closing in on the Kursk pocket. Elon Musk tweeted the US should withdraw from NATO altogether. Meanwhile, European heads of government met in London, then in Brussels again (without the UK) to hammer out a strategy to rearm themselves, while waiting for US tariffs to be slapped on European goods (soon).

The geopolitical landscape of Europe and its relationship with the U.S. are undergoing significant changes. One thing is for sure - neither will ever be the same. As it turns out, Defense Secretary Hegseth’s speech a couple of weeks ago was fairly tamed compared to what appears to be the US administration’s dominant thinking on security.

As the US repositioning vis-a-vis Russia redefines European security priorities, the region faces the compound economic pressure of needing to heavily invest in defense while navigating a less open global trade, which is damaging for an economic bloc that heavily depends on it.

Europe also needs to build up its military capabilities while maintaining credibility with sovereign bond investors, who may have reason to be frightened by the potential for fiscal expansion as European countries still reel from pandemic spending.

But amidst new plans of raising large sums of money to finance defense spending both at a EU and national level - and the urgency shown by all European leaders is proof of the severity of the situation - one bright spot has emerged for investors. European stocks have been flying, buoyed by a combination of anticipated fiscal stimulus and monetary easing.

An additional, fascinating element that might explain European equity (and the euro’s) performance is perhaps the anticipation that Europe will finally close the investment gap and become more geopolitically relevant amidst a common defense. Indeed, the dollar’s global dominance was also partly built on America’s military might, and the euro’s underwhelming history as reserve currency is also a factor of the lack of trust in the capacity of Europe to defend itself.

A US Betrayal of Europe?

Three years into Russia’s full-scale invasion of Ukraine, the war has mostly been a grinding battle of attrition, with neither side achieving a decisive breakthrough. Ukraine, after its successful defense of Kyiv in 2022 and counteroffensives in Kharkiv and Kherson, faced increasing difficulties in 2023 and 2024 as Russian forces adapted, fortified positions, and leveraged superior artillery and manpower.

Throughout these years, while the "collective West” (RIP…) armed Ukraine with mixed success, Russia kept ramping up its military production, factually transforming its economy to fully support the war effort.

For Europe, the war was the initial wake-up call about the continent’s vulnerability and the need for strategic rearmament.

But Europe’s hesitation to fully embrace a surge in defense spending disappeared since the new US administration pledged to end the war in a way that would dismiss European security, by factually rekindling relations with Russia while pulling military aid and intelligence sharing with Ukraine.

Had the United States simply pressured Europe into taking care of Ukraine on its own, while making plans for an orderly and coordinated withdrawal of its troops from the continent (phasing it out, say, over 5-10 years), the change would have been less traumatic and more manageable - and, most importantly, would have signaled continuity in the alliance. Instead, the puzzling attempt to cozy up to Russia - which I hear may be attributable to anxiety from closer Russia-China relations - has bewildered Europeans (that’s the sentence I heard, at least), leaving them with “no cards” (to quote President Trump), at least in the short term, and with the growing concern that America no longer considers itself as Europe’s friend.

To be clear - international relations are complex and constrained by reality. The Europe-US alliance had its ebbs and flows. But never, since the end of World War II, was there the feeling of a historical shift as there is this time around.

To sum it up. Europe’s consternation is not about America’s desire to reduce its footprint and share of NATO burden. It’s the fact that it happened amidst an enthusiastic embrace of Russian foreign policy and thus bluntly against Europe and almost - from a European perspective - to spite the EU, which Trump appears to perceive at times as a geopolitical rival, at times as irrelevant.

Initially, Europe tried to thread the needle not to irk America, as the integrated nature of the NATO alliance would make the continent vulnerable to an abrupt US withdrawal for at least the next decade. Particularly relevant has been the issue of where Europe decides to source its new weapons - not including American-made ones could push President Trump to adopt an even more punitive stance, but including them may hinder the development of a truly European defense industry. But the preoccupation has somewhat ebbed after a series of announcement underscoring America’s willingness to withdraw much sooner than anticipated.

In response, the European European Commission unveiled a comprehensive initiative to bolster the EU's military capabilities. Central to this initiative is the "ReArm Europe" plan, which seeks to mobilize up to €800 billion over the next four years to strengthen Europe's defense infrastructure. A significant component of this plan is a proposed €150 billion loan facility, designed to support member states in joint defense projects, including advancements in air and missile defense systems, as well as drone technologies. ​

The ReArm Europe initiative also emphasizes fiscal flexibility by suspending EU budget rules, allowing member states to increase defense spending without facing financial penalties. The goal is to unlock approximately €650 billion, facilitating investments in critical defense sectors. The plan further proposes redirecting existing EU funds toward defense purposes and lifting lending restrictions of the European Investment Bank to support defense firms.

On that note, Germany, in particular, has announced a substantial increase in its military expenditure. Berlin is discussing with France about being put under its nuclear umbrella, and there are also serious talks among German policymakers about potentially developing their own nuclear deterrence.

If President Eisenhower only knew that one day, Germany could have developed and owned nuclear weapons…

Unsurprisingly, European defense stocks have rallied substantially. Leonardo and Rheinmetall, for instance, who have established a joint venture to develop the next generation of military vehicles for the Italian Army, moved in unison since Trump’s election (with a 98% correlation)…

Will European Equities Continue to Rally Despite Tariffs?

Most analysts - include the one who’s writing this piece - expected both the euro and European stocks to get crushed by the combined effect of US tariffs and sluggish growth. And despite the brief January rally in response to the potential resolution of the Russia-Ukraine conflict, a wobbly peace deal that is punishing for Ukraine would be more of a threat than a positive development for Europe.

But as Europe - and other US allies - began to realize that this US administration is not just marginally more isolationist than expected, but plans to fundamentally change its system of global alliances, and put into question the global order that was created post-World War II, a sense of urgency never seen before took hold in London, Paris and Berlin (the Italians, as usual, love a good hedge…)

The intriguing question going forward is whether this urgency will turn into decisive fiscal stimulus - both defense-related and not. European decision-making tends to be more complex, cumbersome and slower than it is required by the severity of the crisis. But at long last, this seems to be a make-or-break moment.

Markets appear to see it that way. There is a fascinating argument that if European countries did not announce bold plans to rearm and invest heavily in infrastructure and technology, investors would have punished sovereign bonds anyway (yields did go up after the various spending announcements), on the premise that a weak, stagnant EU could become increasingly more debt-laden, and ultimately be easily overcome by a resurgent Russia.

The key to this thinking, which ties geopolitical risk to market moves, is that Russia is now a rogue state (and bent on punishing Europe), with no odds of becoming again the “benign” supplier of cheap energy to the continent. 2025 Russia, in other words, is no longer 2005 Russia. Against this backdrop, investor thinking goes, a stronger Europe is a positive for markets.

This view somewhat clashes with EU markets being extremely sensitive to global trade frictions, both directly - the US is preparing to slap tariffs on European goods - and indirectly.

For Europe, this presents a major challenge. The continent remains heavily dependent on export-driven growth, and U.S. tariffs threaten key industries, from automotive manufacturing in Germany to luxury goods in France.

This makes the market reaction even more surprising…

Conclusion: A Brave New World (And a Nuclear Germany)

The European security and economic landscape is undergoing its most profound transformation since the Cold War. The abrupt shift in U.S. policy has forced Europe to rethink its military strategy, accelerate its defense spending, and brace for economic uncertainty in an increasingly protectionist world.

A decade from now, the Europe that emerges could be stronger, more independent, and more geopolitically relevant - or it could struggle under the weight of its own divisions, unable to coordinate a unified defense strategy and to match the US and China’s dominance in new technologies. The outcome will hinge on whether European leaders can act decisively, sustain investor confidence, and turn the current crisis into an opportunity to reshape the continent’s role on the global stage.

Perhaps most remarkably, the nuclear question has re-entered European discourse. Germany’s discussions with France about nuclear protection - and the faint but growing murmurs of Berlin potentially developing its own nuclear deterrent - underscore just how much the world has changed. If the past few months have proven anything, it’s that nothing is off the table anymore.

Additional Readings:

EU proposes borrowing 150 billion euros in big rearmament push​

Dassault Aviation ready to seize defence opportunities in Europe ​

Europe Inc take evasive action as Trump tariffs hit, braces for second wave​

How Trump's Tariffs May Impact European Growth ​

Defending Europe without the US: first estimates of what is needed