A fragile ceasefire in the Middle East, paying for Europe’s defense push and quarterly country and sector risk update

A ceasefire agreement brokered by the US has temporarily eased fears of a wider regional conflict, bringing down oil prices over -10% to below USD70/bbl, and gas prices down -12%. Global financial markets reacted positively, with both S&P500 and Stoxx Europe 600 up, while corporate bond risk premia narrowed. Regional markets showed varied impacts, notably with Israel's TA-35 index rising 5% above pre-war levels. Yet, uncertainty remains, with ongoing hostilities expected. Our baseline scenario (65% probability) remains a contained military exchange with the current intermittent ceasefire, with 2025 growth at +1.2% in the Eurozone and +1.6% in the US and the oil price around USD68/bbl. However, a downside scenario (10% probability) with escalating conflict would have substantial negative impacts on economic growth (-0.8pp and -0.9pp, respectively) as oil prices would escalate to USD120/bbl in 2025.

European defense investment has surged +75% since the Russian invasion of Ukraine in 2022. But meeting the proposed 3.5% of GDP target will require Germany to spend USD64bn more per year, France USD45bn, Italy USD47bn and the UK USD41bn relative to 2024 GDP levels. So far, only Belgium intends to raise taxes to finance the increase while the UK opts for a shift in its budget by cutting foreign aid. As taxes or spending cuts are politically costly, financing defense with new debt will be the first choice for many governments. But raising the defense spending ratio is not a one-off stimulus – it implies a structural increase in outlays. Relying on debt will therefore put fiscal slippage to a market test: Raising defense spending by +1-2pps of GDP via debt would almost mechanically inflate debt ratios by +10-20pps over the next decade. This could widen sovereign spreads in the eurozone by +10-40bps, worsening the fiscal situation. Resorting to EU-level funding mechanisms offers little relief as this would largely constitute an accounting exercise – interest payments on common EU debt would still need to be financed by national budgets. Another hurdle is that industrial capacity lags – European defense order books grew +70% since 2022 and backlogs +60% at over EUR 1trn, yet capex remains stuck at around 5% of revenue.