De-escalation: Too Good to be True?

War. The term resonates powerfully today as conflicts multiply and intensify around the globe, prompting Europe to embark on a monumental defense effort amid Russia's ambitions to extend the conflict beyond Ukraine.

At the same time, the trade war - marked by escalating protectionist measures, particularly between the United States and the rest of the world - has led to a reevaluation of growth prospects across major economies. Concurrently, discussions surrounding de-dollarization and the search for alternative assets have gained traction, igniting debates about the future of global currency norms.

What are the repercussions for economies? Are safe-haven assets emerging? Can Europe fulfill its defense ambitions, and has the defense sector become a focal point for investment? Jean-François Robin and his team at Natixis CIB Research have provided insights into these developments in their Mid-Year Outlook 2025.

The long-term shift toward protectionism, with the number of trade barriers soaring from 310 in 2010 to over 3,300 in 2023, has culminated in the tariffs imposed by the Trump administration. Rather than benefiting any party, this trade war amplifies existing economic vulnerabilities and hampers global trade. The World Trade Organization now predicts a decline in global trade growth of 0.5%, a stark contrast to its previous forecast of +2.7% last year.

In this climate, the United States appears to be the first to suffer the consequences, as it engages in a trade conflict with the global community while other nations reorganize their trade relations away from the U.S. Our economists have revised their GDP growth forecast from 2.7% to a mere 1.2%. Coupled with a deficit expected to reach 7% by 2026, this creates a concerning policy mix. We expect the Fed to initiate a cutting cycle, with one cut in October, another in December and four more to follow in 2026, at a time when most central banks will be nearing the end of their rate-cutting cycles. Additionally, these uncertainties are hindering investments into the United States.

Latin American countries heavily reliant on exports to the U.S., such as Mexico, which conducts 80% of its exports with the U.S., could be significantly impacted. However, we expect the USMCA treaty to survive, allowing all USMCA-compliant products to be exported at zero tariff rates. Meanwhile, Argentina and Brazil should be able to export agricultural products to China.

It appears that China is emerging as the winner in this trade war. The U.S. administration has been compelled to reduce tariffs on Chinese goods, and the impacts of embargoes on rare earths have proven considerable. China has shown resilience, with growth rates projected at around 4%, bolstered by increased exports to other Asian nations like Vietnam and Thailand, as well as to Europe.

Indeed, to sustain its growth, China is ramping up production, and exports to prevent overcapacity, which, combined with a depreciating yuan, poses a substantial threat to Europe. This leaves the continent caught between the hammer and the anvil of rising U.S. tariffs. Nevertheless, Europe’s growth rate is expected to hover around 1%, driven by Spain and Germany. As Germany eases its budgetary constraints to support defense spending, it is becoming the engine of Europe. This should contribute positively to growth in France, the second-largest arms exporter worldwide.

As the U.S. grapples with soaring national debt projected to reach 155% of GDP by 2027, discussions surrounding the de-dollarization of the global economy have gained prominence. Observers note a marked decline in the dollar's dominance, with its share of global reserves dropping from 73% in 2001 to approximately 58% in 2024.

Concurrently, countries are increasingly pursuing bilateral trade agreements in local currencies to mitigate reliance on the dollar. If we factor in the slowdown in global trade and the electrification of the economy, its predominance is expected to gradually decline, even though it still accounts for 90% of global transactions.

This backdrop sets the stage for a potential shift in asset preferences. Europe is well-positioned to benefit from the rebalancing of investor portfolios, driven by favorable growth prospects and interest rate differentials. Despite strong performance, European valuations remain significantly undervalued compared to their U.S. counterparts. Furthermore, a weaker dollar combined with U.S. political risks is likely to encourage investors to diversify away from U.S. equities, which currently make up 71% of global market capitalization. The euro is expected to strengthen to 1.18.

Gold is another prominent emerging asset that has been steadily appreciating since the 2009 financial crisis, when central banks began diversifying their reserves and reducing their dollar holdings. This trend has accelerated due to the war in Ukraine and the freezing of assets from countries not aligned with the West. However, due to its extreme valuations, gold should be viewed as a long-term protective strategy and incorporated into investment portfolios for diversification.

In other commodities market, our economists maintain their forecasts for gas and crude oil prices, at $63 to $65 per barrel by the end of the year. Events in the Strait of Hormuz are unlikely to affect prices, as no party has a genuine interest in escalating the situation. Additionally, while the rising demand for metals and rare earths necessary for armaments is not expected to significantly influence prices - given that the quantities involved are relatively small compared to the overall market - companies producing the specialized alloys required for the industry may appreciate.

To prepare for a potential high-intensity conflict with Russia, expected by 2030 or even as early as 2028 according to some sources, Europe will likely need to allocate 5% of its GDP to defense spending by 2035, up from the current NATO target of 2%, which it struggles to meet. This new objective allocates 3.5% for military expenditures and 1.5% for infrastructure, intelligence, and cybersecurity. This represents a significant increase of 3 percentage points of GDP, amounting to approximately €500 billion.

Can these increased expenditures benefit the European economy? Are the valuations in the defense sector, which have appreciated significantly, sustainable?

Our economists expect this rise in defense spending to generate an additional growth effect of around 0.3% to 0.6% by 2028. However, the overall economic impact will depend on the total amount spent, the composition of expenditures, and whether they are produced domestically or imported.

Regarding this point, while 65% of these defense expenditures must be allocated locally or with countries that have signed defense agreements with Europe, approximately 80% of the defense supply chain relies heavily on foreign suppliers, which limits the potential economic multiplier effect to 0.7.

Moreover, attention must shift to how these funds are allocated, particularly in fostering innovation and supporting smaller defense contractors that are crucial for maintaining competitiveness. For instance, research and development accounts for 16% of the U.S. defense budget - approximately $150 billion in 2024 - while in Europe, it stands at only €13 to €14 billion, or around 5% of the total budget. This staggering tenfold difference makes it essential to focus on closing this technological gap.

We will dedicate a webinar next week to explore how to support industrials  in this defense effort, along with a comprehensive special report. Stay tuned!