The great revival of Europe’s industrials

A pivot in Germany

“We know we need to do more… Europe needs to grow up and Europe needs to be able to defend itself,” said Friedrich Merz, Chancellor of Germany in early March this year. At that time, he unveiled a plan that would unlock hundreds of billions of euros for infrastructure and defence investments, breaking the prior tight controls on Germany’s borrowing limit.

Merz was planning a EUR 500bn infrastructure fund to invest in areas including transportation, energy grids and digital infrastructure. This has now been approved by the German government, to be spent over 12 years (c.1% of GDP per year). Furthermore, Merz drove through a constitutional amendment to exempt defence spending that exceeds 1% of Germany’s GDP from the “debt brake” (a fiscal rule limiting budget deficits to 0.35% of annual GDP). This means Germany’s defence spending is now virtually uncapped. In addition, German states, which had been prohibited from taking on new debt, will be allowed to incur new annual debt of 0.35% of GDP, the same as the Federal government.

In sum, we expect that Germany’s fiscal boost could lift annual GDP growth by as much as 2 percentage points over the coming decade. Since Germany accounts for a quarter of the Euro area economy, this alone translates into a 0.3-0.5% lift to annual Euro area growth.

In addition, for the wider European Union (EU), the European Commission has unveiled the ReArm Europe plan. This would activate a mechanism to allow countries to use their national budgets to spend an additional EUR 800bn on defence by 2030, without triggering EU budgetary penalties. Given other EU countries have a lower debt capacity than Germany, implementation of this plan could face more hurdles.

Direct and indirect beneficiaries

Not all of the German and European defence spending will benefit Europe. Indeed, the European Commission estimates that nearly 80% of defence purchases made by EU countries since the start of the Ukraine war were from outside the EU, with over 60% from the US alone. With US tariff negotiations in the background, more defence purchases by the EU from the US could be part of a trade deal.

European leaders recognise, however, the need for a massive industrial production ramp-up within Europe itself to be truly capable of defending the region. The aerospace and defence industry in Europe, which comprises 26% of the MSCI Europe Industrials sector, would be a direct beneficiary of increased defence spending. We expect other segments of the industrials sector such as electrical equipment, machinery, building products and construction and engineering, to also benefit from greater infrastructure and defence spending.

In total, over two-thirds of the industrials sector would benefit directly from Europe’s fiscal boost, while remaining sectors benefit indirectly from the broader uplift in economic growth.

Sustained earnings momentum

The industrials sector saw a good Q1 earnings season, delivering a 7% positive earnings surprise. Consensus expectations are for earnings to grow by 10% in 2025 and 12% in 2026. With Europe’s fiscal boost kicking in especially in 2026, we expect the multi-year tailwind to support earnings momentum for the industrials sector.

We are also positive on other growth trends that benefit the sector, such as civil aerospace, electrification and sustainable construction. Civil aerospace benefits from strong global air travel demand. Electrification demand is growing from urbanisation, heavy AI investments with significant power demands and the increasing penetration of electric vehicles globally. Meanwhile, global sustainability trends are driving an upgrade to sustainable construction, energy efficiency and green buildings.

Overcoming risks

Valuation of the Europe Industrials sector is currently elevated, with consensus 12-month forward price-earnings ratio at 20x, compared to the 10-year historical average of 18x. However, we expect the elevated valuation to be sustained by the strong earnings momentum. Another risk is that the sector currently generates 27% of sales from the US, which could face tariff headwinds, subject to ongoing trade negotiations. A majority of sector revenue currently originates from outside Europe as well, so a stronger Euro could translate into an earnings headwind. Nonetheless, we are bullish on the sector as we expect investors to be focused on the sustained earnings tailwind and a European industrials revival from greater infrastructure and defence spending.

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