Brave New Europe? Redefining trade, defense, and power

The old playbook doesn’t work anymore. Europe is at a crossroads.

U.S. tariffs loom over its export-driven economy, potential Ukraine ceasefire discussions are unpredictable, and German election results are unfolding. The message is clear: Europe must redefine its future on its own terms.

Long-standing transatlantic alliances are becoming more complex, intensifying the urgency of security negotiations. Compounding these challenges, Europe faces sluggish growth, and the European Central Bank's battle against inflation isn’t over yet.

This past week put all these issues to the test. Here are the 5 lessons we're taking away.

1. Tariffs are about more than trade

Whether U.S. tariffs are just a negotiating tactic or a real threat is uncertain, but ongoing discussions threaten Europe’s export-driven economy. Let’s break down what we’ve learned.

The opening salvo of 25% tariffs on steel and aluminum imports, set for March 12, may not have a huge impact. Although the EU is the third-largest supplier to the U.S., the affected goods account for only €9 billion, or 0.05% of the region’s GDP. ¹ The move represents a first step to bigger threats.

Details of potential reciprocal tariffs are expected in April, but their definition and impact are ambiguous.

If these tariffs just aim to equalize the import tariff rates between the U.S. and EU, the impact might be limited, given the U.S.'s 3.4% and the EU's 4.1% average tariff levies. But, if applied literally across thousands of product categories, certain items could see big hikes (see motor vehicles, where the U.S. average rate to the EU is 2.7% vs. the EU’s at 8.5%).²

The challenge intensifies with U.S. threats of additional 25% tariffs or more on cars, pharmaceuticals, and semiconductors. The U.S. is the top market for EU-made cars, with Germany and Italy particularly exposed.³ Complexity further increases if 'reciprocal' tariffs include value-added taxes (VAT).

Equally important is the EU's response. Drawing from its 2018/19 playbook, the EU might impose high tariffs on products linked to U.S. political bases. The new Anti-Coercion Instrument (ACI) also allows broader measures, including restrictions on services, intellectual property, foreign investment, and government contracts.

Trade is not just an economic issue but a strategic one.

2. Bolstering defense seems unavoidable

With trade uncertainty at its highest since COVID and global conflicts also at an 80-year high, Europe must strengthen its defense.⁴

Last week marked three years since the Ukraine war began. The ongoing turmoil and recent shifts in U.S. policy highlight the urgent need for enhanced defense capabilities to deter threats and offer any security guarantees to Ukraine in a peace deal.

For decades, Europe has under-invested in defense, spending well below NATO's 2% GDP target. From 1990 to 2021, this shortfall reached about €1.8 trillion, with Germany responsible for a third due to major post-Cold War cuts.⁵

However, the tide is turning. EU nations are ramping up military budgets. In 2014, Greece was the only EU country in NATO to meet the 2% target, but by last year, 17 NATO-EU members are expected to have reached it. With calls for further increases, loudly echoed by President Trump, the bloc’s defense spending could rise to 2.5%-3% of GDP in the coming years.

Markets are taking notice: The Stoxx Europe 600 Aerospace and Defense Index is up over 30% since August.

However, European policymakers have historically been cautious about funding spending with new debt. They will need to balance the security need versus potential deficits.

3. The lines between the economy and security are blurred

Geopolitical shifts are challenging transatlantic alliances, exposing vulnerabilities and reorienting supply chains. Energy and technology have become critical frontlines.

The war in Ukraine underscores these issues. Before the conflict, Russian energy accounted for 35% of the region’s imports.⁶ Sanctions thereafter imposed restrictions, but now, potential peace talks could restart flows to Europe.

This raises a key question: how reliant should Europe and the West be on Russian gas post-conflict? Some argue easing the brakes could alleviate high energy prices.

Efforts towards energy independence have been underway. The region has increased its capacity for the regasification of liquified natural gas (LNG) by 75 billion cubic meters since the war began and plans a 60% expansion between 2021 and 2030.⁷ North American export capacity is set to double by 2028.⁸

But it might not be enough.

Continued progress is needed to close the energy gap and support AI development. For instance, natural gas accounts for over 40% of U.S. data center consumption. Yet, Europe’s industries face meaningful regulatory barriers, which the IMF equates to tariffs of 45% for manufacturing and 110% for services. ^9,10

High demand suggests full energy independence is unlikely in the near term. This presents a challenge: balancing the security risks of overreliance on Russian gas against its immediate cost benefits. Policymakers are expected to diversify energy sources, but questions remain about forging a unified strategy amid internal divisions.

4. German Elections just offered a litmus test for Europe’s next chapter

The preliminary results are in from Sunday’s German election. The center-right CDU/CSU emerged with 28.5% of the vote, while the far-right AfD captured 20.8%, the center-left SPD secured 16.4%, and the Greens garnered 11.6%. The leftist Linke, with 8.8%, crossed the 5% threshold to qualify as a parliamentary party, but the far-left BSW and liberal FDP, with 4.97% and 4.33% respectively, have so far fallen short.¹¹

This positions the CDU/CSU and SPD with a combined 52% of seats, making a grand coalition between the two parties the most likely scenario, with Friedrich Merz expected to take the helm as Chancellor. This arrangement sidesteps the complexities of involving a third party in the governing coalition, potentially smoothing the path for negotiations.

However, enacting constitutional changes will be a hurdle. Despite the highest voter turnout in over three decades, the major parties recorded their lowest vote shares ever. With only 52% of the seats, the potential centrist coalition lacks the two-thirds majority required for constitutional amendments, necessitating collaboration with fringe parties.

A critical issue will be the reform of the "debt brake," which currently limits Germany’s budget deficit to 0.35% of GDP. Adjusting this fiscal constraint could be essential for enabling necessary defense spending, which again, marks a significant step in shaping Germany's—and Europe's—future.

5. Building resilient portfolios can help defend and grow wealth

Europe is at a pivotal moment. The war in Ukraine, potential U.S. tariffs, and shifting alliances highlight the need for it to chart its own course—one that strengthens defense and embraces innovation.

Achieving this in an environment where governments have limited capacity or willingness to spend is challenging. Long-term growth will require collective effort.

Despite the uncertainty, European stocks have reached record highs. The Euro Stoxx 50 has outperformed the S&P 500 in the first seven weeks of 2025, and Germany's DAX Index has slightly outpaced U.S. stocks over the past four years.

This underscores an important lesson: the market is not the economy. For example, while the auto sector is crucial to Europe’s economy, auto manufacturers make up just 5% of the Euro Stoxx 50 Index.

Recent market strength has been fuelled by better-than-expected earnings and a recovery in valuations. Much is unknown, but a potential ceasefire in Ukraine, a softer U.S. stance on tariffs, or a continued earnings recovery could provide near-term optimism.

In the meantime, we stay selective, focused on where structural drivers – forces driving durable, non-cyclical growth—can “power through” the macroeconomic challenges. We believe increased capital investment supports a number of companies across the industrials and technology sectors.

Your JPMorgan team is here to help navigate these developments and explore potential opportunities.