European Stocks Face Pivotal 2026 as Germany’s €500bn Spending Plan Meets China Competition

Jan 13, 2026 - 12:00

Berlin’s historic abandonment of fiscal conservatism promises €127 billion annual investment surge, but Morgan Stanley’s 3.6% earnings forecast versus consensus 12.7% reveals deepening divergence between stimulus hopes and structural reality strangling European competitiveness

The Fiscal Revolution Nobody Expected

Germany has torn up its economic playbook. After decades of rigid adherence to balanced budgets and the constitutional debt brake, Europe’s largest economy embarked on the most significant fiscal expansion since reunification in 1990. The numbers are staggering: €126.7 billion in investment for 2026—the highest in German history—backed by €174.3 billion in borrowing and a €500 billion Infrastructure and Climate Neutrality Special Fund spread over twelve years.

This represents nothing less than a philosophical revolution. The government that once lectured profligate southern European nations about fiscal discipline is now borrowing at triple 2024 levels to fund infrastructure modernisation, defence expansion, and green transition investments. Germany’s fiscal deficit is projected to surge from 2.7% of GDP in 2024 to 4.75% in 2026, with the structural primary balance widening from -0.9% to -1.8% before any consolidation begins.

For European equity markets, this should theoretically be transformative. Cement producers, construction materials companies, defence contractors, rail infrastructure firms, and industrial machinery suppliers stand to benefit from the most sustained public investment programme in German history. Yet investor enthusiasm remains decidedly muted, reflecting profound scepticism about whether fiscal stimulus can offset the structural headwinds battering European competitiveness.

Defence Spending: The One Certainty

If any sector offers genuine visibility, it’s defence. Germany’s 2026 budget allocates €82.7 billion for the Bundeswehr, a €20.2 billion increase from 2025. Combined with the €25.5 billion Defence Special Fund, total military spending reaches €108 billion. Defence expenditure will climb to 2.8% of GDP in 2026 and is targeted to reach 3.5% by 2029—well above NATO’s 2% minimum that Germany struggled to meet for years.

Military procurement saw the largest budget increase, rising €16.8 billion to account for 27% of defence spending. This covers everything from €1.5 billion for new vehicles to €2.74 billion for digitising Bundeswehr assets, €1.4 billion for expanding the PUMA infantry fighting vehicle fleet, and substantial allocations for ground-based air defence systems. The Federation of German Security and Defence Industries reports membership surging from 243 to 440 companies since November 2024, with most new entrants being small and medium enterprises pivoting from struggling automotive and machinery sectors into more stable military contracts.

European defence stocks have rallied 78% through late 2025, yet further gains appear plausible if procurement acceleration continues. France’s Safran, Germany’s Rheinmetall, Italy’s Leonardo, and Sweden’s Saab have transformed from dormant holdings into market darlings. The shift reflects not temporary political posturing but structural realignment following Russia’s invasion of Ukraine and deteriorating security architecture across Eastern Europe and the Middle East.

Infrastructure Reality Check

Beyond defence, the investment story becomes considerably murkier. Germany plans €48.9 billion drawn from the Infrastructure Special Fund in 2026, targeting transport networks, digital infrastructure, hospital modernisation, and energy systems. An additional €21.7 billion comes from the Climate and Transformation Fund for decarbonisation projects. Railways alone—through Deutsche Bahn—claim nearly one-third of the special fund allocation.

However, implementation risk looms large. Germany has consistently underdelivered on infrastructure targets in recent years due to bureaucratic delays, planning bottlenecks, and skilled labour shortages. The 2025 budget already shifted money away from originally planned infrastructure projects toward social spending and electricity subsidies for businesses. The Ifo Institute calculates that of the ten largest investment items in the core budget totalling €24.4 billion, only €5.8 billion will actually fund infrastructure—the rest represents accounting manoeuvres to inflate investment figures.

Critics warn of “creative bookkeeping” designed to bypass fiscal constraints rather than genuine economic stimulus. The Court of Auditors flagged that even with special fund contributions, the Climate and Transformation Fund faces gaps in covering financial liabilities. By 2027, the government faces a projected €34.4 billion budget deficit that finance minister Lars Klingbeil plans to reduce to €12 billion through reserve reallocations and revised tax forecasts—precisely the accounting gymnastics that undermine confidence in fiscal sustainability.

The China Overcapacity Crisis

While Germany ramps up public spending, a more immediate threat is crushing European manufacturers: Chinese overcapacity in strategic sectors. Overcapacity in electric vehicles, solar panels, steel, aluminium, and chemicals is depressing global prices and squeezing profit margins across European industry. In Germany alone, profit margins for non-financial companies have fallen 5 percentage points over three years, with steeper declines in manufacturing sectors directly exposed to Chinese imports.

The structural nature of this challenge cannot be overstated. China invested nearly as much in clean energy in 2025 as the United States and European Union combined, cementing its status as the world’s clean technology powerhouse. Chinese companies lead manufacturing across most supply chains—from solar cells to lithium batteries to wind turbines—with decade-long head starts and substantial cost advantages. European efforts through the Net-Zero Industry Act, which aims for 40% domestic production of annual deployment needs by 2030, face the reality that Chinese manufacturers operate at scales European firms cannot match without massive ongoing subsidies.

Goldman Sachs Research identifies increased Chinese competition as reinforcing structural weaknesses already plaguing the euro area economy: demographic decline, overregulation, and persistently high energy costs. These headwinds explain why European GDP growth forecasts remain anaemic at 1.1-1.3% for 2026—well below the continent’s potential and insufficient to absorb surplus capacity or reduce unemployment meaningfully.

The Earnings Divergence

This brings us to the core problem confronting European equity investors: the yawning gap between analyst consensus expectations and more sober assessments. Morgan Stanley’s European equity strategists forecast earnings growth of just 3.6% for 2026, dramatically below the bottom-up consensus estimate of 12.7%. This divergence reflects a familiar pattern—European equities typically begin each year with elevated forecasts that are gradually downgraded as reality intrudes.

The question is whether 2026 marks an inflection point. Optimists point to Germany’s fiscal impulse, potentially improving Chinese demand as Beijing implements stimulus measures, and ECB monetary accommodation as inflation normalises. J.P. Morgan strategists forecast eurozone earnings growth approaching 15%, driven by easy base effects, improving macro conditions, rising liquidity, and German infrastructure spending finally materialising.

Yet the pessimistic case appears equally plausible. Delays in implementing fiscal programmes are almost guaranteed given Germany’s track record. Chinese overcapacity shows no signs of abating—if anything, it’s intensifying as Beijing prioritises manufacturing employment over profitability. Energy costs, while retreating from 2022 peaks, remain approximately 40% above pre-pandemic levels for industrial users, driving an exodus of energy-intensive industries. Surveys indicate 75% of German energy-intensive companies are shifting investments abroad to regions with lower power costs and fewer regulatory burdens.

French Political Fragmentation

Political uncertainty compounds economic challenges. French equities trade at an outright discount to the EURO STOXX 50—historically a warning sign reserved for major crises. French stocks have underperformed by 15% since January 2024 amid recurring government instability. While markets showed resilience when the government survived October’s no-confidence vote, underlying political fragmentation remains unresolved. The risk premium investors demand for French exposure has widened significantly.

The upcoming US midterm elections in November 2026 add another layer of uncertainty. Potential shifts in American trade policy could trigger renewed tariff threats targeting European automotive and aerospace exports. The polarisation of global trade into US-led and China-led blocs forces European companies to navigate increasingly complex supply chain decisions with no clear optimal path.

The Investment Case

Despite formidable challenges, European equities offer compelling value for patient investors. The STOXX Europe 600 ex UK Index trades at 14.8 times 2026 consensus earnings—slightly above its long-term average but justified by improving fiscal dynamics and substantially cheaper than the S&P 500’s 22.5 times valuation. Sectors positioned to benefit from German stimulus—select industrials, materials, and banks—present tactical opportunities if implementation accelerates.

European banks trading at 9-10 times earnings represent a particular anomaly. The sector’s recent outperformance has been driven by earnings growth rather than valuation expansion, as investors remain wary after the long post-financial crisis winter. If Germany’s fiscal stimulus drives credit growth and loan portfolio expansion, banks could see sustained earnings momentum even as net interest margins compress.

Yet the broader verdict remains uncertain. Germany’s fiscal revolution represents Europe’s most ambitious attempt in decades to address competitiveness deficits through public investment. Whether €500 billion in infrastructure spending, coupled with defence rearmament and green transition funding, can offset Chinese overcapacity, energy cost burdens, and demographic decline will determine not just 2026 stock returns but the continent’s economic trajectory for years ahead. The answer will reveal whether fiscal policy alone can rescue a growth model under siege from multiple directions—or whether structural reform remains the only viable path forward.