Defence sector: A bright spot in Germany’s economy

Germany is setting bolder goals for defence spending to unlock a more powerful military and faster growth, but its economic impact is likely to be soft.

Given the dismal economic performance of Germany with zero growth over the last three years, it might be surprising to hear that the country’s blue-chip stocks are handily outperforming other national stock market indices with a 20 per cent gain so far in 2025. Two industries driving this performance are industrials and the defence sector. Both are set to benefit from the large stimulus measures which the new government is counting on to turn the ailing economy around.

The stimulus and the general remilitarisation of Germany, in line with fellow member-states in the North Atlantic Treaty Organization (NATO), are undoubtedly profiting defence companies. The sheer scale of the stimulus is impressive and is supposed to bring German military infrastructure ahead of peers. Even if it is not brought down by a toxic quagmire of German-style regulation and hesitation, it could be a turning point for domestic forces. Whether this translates to greater structural change and economic growth – with politicians promising well-paid jobs and regional revitalization across the board – remains to be seen. However, this will not deliver a lasting boost on the German economy.

Limited solutions

Germany has spent the last decade not spending all that much; instead, it focused on bringing down public debt through strict adherence to the constitutional debt brake. That was until the Russian attack on Ukraine shocked Berlin into reconsidering the importance of a strong national military, with the spending surge seen in Graph 1. In 2022, former Chancellor Olaf Scholz delivered the Zeitenwende speech which included the passing of a EUR 100 billion (USD 114 billion) fund to boost the Bundeswehr, its federal armed forces. This also propelled Germany to hit the NATO spending target of 2 per cent of GDP for the first time in 2024, even if the country has been committed to that level of defence spending since 2006.

The new government under Chancellor Friedrich Merz then decided to exempt military spending above 1 per cent of GDP from the debt limit and provide a EUR 500 billion (USD 570 billion) fund to finance infrastructure investments. He also sought to meet an even higher military spending goal of 3.5 per cent of GDP and boost defence infrastructure budgets by another 1.5 per cent of GDP by 2029. This is projected to push the budget deficit to above 3 per cent, which is not a problem given Germany’s debt-to-GDP ratio of around 62 per cent, as seen in Graph 2.

Despite having its finances in order, challenges lie ahead. First, Germany may no longer be home to the defence companies of the future. The Russia-Ukraine war has shown that large and expensive weapons systems such as fighter jets and armoured vehicles have lost some of their appeal to smaller, easier to produce, and cheaper combat equipment like drones. Germany can respond to this shift by nurturing homegrown tech companies like Helsing, a four-year-old company that has become the most valuable startup locally. Initially focused on software and AI, the company gained from its pivot towards defence and started producing drones in 2024.

Established companies may also adapt: for example, industry heavyweight Rheinmetall is working with Anduril, one of the most popular defence startups in the US, to keep up with drone production. Given that the fragmented European defence industry is currently not the most conducive place for innovative companies to emerge, partnering with US firms may be an easier way forward.

Second, even if Germany had relevant defence companies to buy armaments from, it could still be difficult to effectively rearm while supporting the local economy. In contrast to the US, the EU has a multitude of defence companies, resulting in a dizzying selection of weapons systems. To be effective, German businesses and its European peers would need to consolidate to achieve economies of scale. However, a less fragmented industry would make it harder to rely on defence spending to kickstart the local economy, given that benefits will have to be shared with foreign partners.

Assuming German companies can modernise their production and Germany were to maintain some of its national production, the positive impact on the economy remains limited. While manufacturing contributes 18 per cent of GDP in value added and 19 per cent of total employment, it has declined in recent years. For the defence sector itself, output amounted to roughly 0.2 per cent of GDP in 2023, steady from 2014 levels. Moreover, as productivity increases, jobs in the defence industry may shift from blue-collar roles to more specialised positions, which are already in low supply within Germany. Although the four largest German weapon manufacturers have increased their employment by 7,600 over the past four years and are partly repurposing dormant factories, this is unlikely to halt deindustrialisation.

The way forward

Germany hopes that increased military infrastructure spending can spill over to other sectors and increase productivity by around 0.3 percentage points, creating significant GDP gains in the long run. This, however, depends on how companies adapt to modern weapon manufacturing techniques and if Germany can truly spend more. By prioritizing the rearming of the Bundeswehr, it seems unlikely that infrastructure allocations will increase significantly in the short term, limiting this upside.

We assess that the German government is correct in investing heavily now towards defence infrastructure and its military. Both are long overdue and fiscally doable, and create some market dynamism for companies which are most likely to profit from the state spending boost. German stocks may get a temporary lift from improved market sentiment, but it will not last unless tactical economic reforms are implemented for long-run growth. Until then, Germany will just continue waddling through.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.