Germany's Defense Surge and U.S.-EU Tariffs: Navigating Risks and Opportunities in Automotive and Defense

The German economy is at a crossroads, balancing a historic military buildup against escalating trade tensions with the U.S. While Chancellor Friedrich Merz's government races to resolve tariffs threatening the automotive sector, its defense spending spree is creating new opportunities for firms like Rheinmetall and Airbus. Investors must weigh geopolitical risks against long-term strategic bets in two of Germany's most vital industries.

Defense Spending: A Multi-Decade Tailwind for Industrial Giants

Germany's defense budget has surged to €86 billion in 2025, up 28% from 2023, with plans to hit 3.5% of GDP by 2031 en route to NATO's 5% target by 2035. This spending boom is fueling demand for advanced equipment:
- Rheinmetall (ETR:RHG): Benefiting from a €8.5 billion contract to supply 155mm artillery ammunition and its role in developing next-gen tanks like the Leopard 3.
- Airbus (ETR:AIR): Positioned to win contracts for drone systems and cyber defense, leveraging its European aerospace leadership.

The defense sector's trajectory is clear: long-term growth driven by geopolitical instability and NATO's rearmament. However, risks include fiscal overreach—Germany's debt-to-GDP ratio is projected to hit 62.5% in 2025—and reliance on U.S. technology for critical systems like air defense.

U.S.-EU Trade War: A Near-Term Threat to Automotive

The automotive sector faces immediate headwinds as U.S. tariffs on German car imports, now 25%, have slashed exports by 25% year-on-year through May 2025. The stakes are massive:
- BMW (ETR:BMW) and Daimler (ETR:DAI) face combined annual tariff costs exceeding €500 million, per industry estimates.
- A 50% tariff threat looms if Merz's negotiations with Trump fail by July 8, compounding losses.

Merz's push for a “quick deal” with the U.S.—including accepting a 10% baseline tariff—risks long-term damage. Critics argue that sectoral carve-outs could erode EU trade rules and embolden protectionism. For investors, the automotive sector remains highly speculative until tariff resolution, with short-term earnings pressure outweighing electric vehicle (EV) innovation gains.

The Merz-Trump Negotiation Pivot: Key to Sectoral Outcomes

Chancellor Merz's strategy is a high-wire act:
1. Defense as a Diplomatic Lever: Germany's military modernization could be framed as a counterweight to Russian aggression, aligning with U.S. interests.
2. Trade Compromises: Accepting a 10% tariff in exchange for U.S. concessions on semiconductors or EV subsidies could stabilize automotive margins.
3. Geopolitical Realignment: Germany's shift from pacifism to NATO leadership may attract U.S. investment in shared defense tech, boosting firms like MTU Aero Engines (ETR:MTX).

Investment Strategy: Defense Now, Automotive Later

• Defense Plays:
• Rheinmetall (RHG): Buy on dips; its ammunition and armored vehicle contracts are recession-resistant.

• Airbus (AIR): Long-term exposure to drone and cyberdefense programs, though geopolitical volatility remains a risk.

• Automotive Caution:

• Avoid aggressive bets on BMW or Daimler until post-July tariff clarity. Monitor Volocopter (electric air mobility) as a niche alternative to traditional carmakers.

• Hedging:

• Use ETFs like DBX (double-inverse Euro ETF) to hedge against EUR weakness if trade tensions escalate.

Conclusion: A Dual-Track Economy

Germany's defense surge and automotive crisis reflect its broader geopolitical realignment. Investors should prioritize Rheinmetall and Airbus for their exposure to structural defense spending, while treating automotive stocks as high-risk until trade tensions abate. The Merz-Trump talks in July will be pivotal—failure could push the EU into a retaliatory spiral, but success might unlock a new era of transatlantic industrial cooperation. Stay nimble, but bet on the sectors building weapons, not just cars.