European Equity Strategy: European Fiscal Stimulus Revisited

In a new Macro-to-Micro report from Citi Research, a team of analysts and economists led by Head of European Equity Strategy Beata Manthey takes a new look at recent European commitments to large fiscal stimulus via infrastructure and defense spending, a note that revisits an earlier assessment of these commitments’ implications.

We now expect European Union (EU) spending plans to lift gross domestic product (GDP) earlier and by more, with an extra 0.4 pp added to GDP growth in 2027. And this stimulus could add another 3% of European earnings per share (EPS) growth over the next five years, sparking a long-term index re-rating.

In early March, Citi Research explored the macroeconomic impact of Europe’s Re-Arm EU package (since relabeled Readiness EU), which allocates €800 billion, or 1.1% of EU GDP per year, over four years with the objective of reaching 3% of GDP by 2030. Additionally, Germany approved a change to its constitutional debt brake, uncapping defense spending, and unveiled a €500 billion infrastructure fund.

There have been several developments since then. 

• The 3% GDP target has been raised to 3.5% for “core defense,” plus 1.5% for “broader defense and security” by 2035.
• Germany has unveiled actual issuance/deficit plans, which envision a budget deficit widening from just below 3% of GDP in 2024 to above 4% by 2027 and staying close to 4% until 2029. While details of how the money will be spent still lie ahead, the new plans amount to a considerable shift in Germany’s fiscal stance compared with expectations at the start of the year.
• No other big EU countries have activated the National Escape Clause, which offers leeway within EU fiscal rules to spend the €650 billion portion of Readiness EU. As for the other portion of Readiness EU — the €150 billion in EU Security Action for Europe (SAFE) loans — several countries have said they’ll apply, but for most EU countries, the cost savings from drawing down SAFE loans is seen as too limited on its own to be an incentive. That said, all countries except Spain have committed to the new 5% NATO target.

Studying the macro impacts

Back in March, we estimated that if fully implemented, the planned 1 pp of GDP per year of additional spending would start having an effect on euro-zone GDP in 2026, adding 0.2 pp that year and scaling up to +0.7 pp in 2028–2029. The fiscal impulse in Germany now looks bigger and more front-loaded, with some effects likely seen in the second half of this year. 

We expect the stimulus from the recent fiscal announcements to be mostly concentrated in Germany. In the rest of the euro zone, lifting defense spending to 3% of GDP per year was already an ambitious goal given fiscal constraints and a lack of fiscal support. The additional 1.5% of GDP could spur additional projects, but we expect actual expenditures will be much smaller and more back-loaded than in Germany. Rising public investment in other European countries is also likely to reduce the room for additional projects. 

All things considered, we estimate the new spending plans will lift euro-zone GDP a bit earlier and a bit more than our March assumptions. We factor in 5% additional spending cumulatively between now and 2030, compared with our March assumption of 4% by 2029, and assume slightly higher fiscal multipliers.

We expect the fiscal impulse to peak in 2027, adding around 0.4 pp to GDP growth, with 0.2 pp added in 2025–2026. Eventually, we see the level of GDP as about 1% higher than our pre-March baseline by the end of 2029.

Implications for equities

Turning to equities, bottom-up consensus currently points to a ~8% Stoxx 600 EPS compound annual growth rate (CAGR) through the end of 2029. Our models suggest the European defense and German infrastructure packages could add another 2% and 1% of EPS growth per year, respectively. 

A 3% higher five-year EPS growth CAGR is quantitatively associated with a ~1.5x higher 12-month forward price-to-earnings ratio (PE). Europe is already cheaper than what’s implied by our regression and has scope to rerate ~1.5x PE points given such an increase in EPS expectations. An optimistic scenario for a lower equity risk premium could add around 0.5x, resulting in a net re-rating of 10% to 15% over the long term.

In terms of sectors, we see these re-rating dynamics as favoring Cyclicals, Value and SMID caps. We also note that Defense sectors are still “under-owned.” Currently, Defense comprises ~5% of the Stoxx 600 and Germany’s DAX index, with earnings weight of ~2% for both indices. Outside of France, U.S. and European countries generally have similarly small exposures to Defense stocks, which gives indices scope to expand their exposure to such names. 

German equities clearly stand as primary beneficiaries of both domestic and EU fiscal spending. Analysts’ consensus expects 13% EPS CAGR through 2029, up from expectations for 11% at the start of the year. Our model suggests the additional EPS impact from German stimulus is 2% per year through 2029 after already being revised up another 2% year to date, resulting in a compound growth rate of ~15%.

This represents 10% more total German EPS in 2029 vs. current bottom-up scenario forecasts. Calculations using earnings weight suggest such an increase would improve overall European earnings by ~1.5%. But this may be low; historically, when German EPS has grown by 10%, Pan-European EPS has grown by ~6%.

Improving economic conditions and market outlooks for Europe could also encourage both domestic and international investors to increase their long-term allocations to European equities, with such flows spurred both by rotation into Europe via diversification away from the U.S. and by more domestic participation from European investors.

Europe has seen a flow revival in 2025, with year-to-date inflows of ~2% of assets under management, and we see diversification away from the U.S. as still likely, since global investors have come to “over-own” U.S. equities in past years while underinvesting in Europe. With shifting perceptions around the predictability of U.S. economics, investors could stay desirous of diversifying into markets such as Europe over the medium term.

Turning to domestic investors, households have the capacity to increase their equity allocations: According to national accounts, European households only hold ~20% of their savings in equities, compared to ~40% for the United States. Germany is also actively exploring ways to encourage participation by retail investors through a number of policy proposals.