Muzinich Weekly Market Comment: The case for defence

February 24, 2025

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In our latest roundup of the key developments in financial markets and economies, talk of a material increase in EU defence spending had an immediate effect on long rates and the region’s investment grade market.

Uncertainty was the watchword for last week. Donald Trump ramped up the pressure on Ukrainian President Volodymyr Zelensky, a senior European Central Bank (ECB) official set the hares running over a potential pause to monetary easing, while a disappointing forecast from major retailer Walmart highlighted the pressures facing lower-income consumers in the US.

Government bond yields rose, particularly in Europe due to increasing expectations of a rise in defence spending. Credit sub-asset classes most sensitive to rate moves, particularly European investment grade and, to a lesser extent, its US counterpart, were the notable underperformers.

Meanwhile, the strong February for both European and US high yield continued, while emerging market investment grade and high yield bonds eked out modest gains.

US stocks were broadly flat, while European equities (including the UK) had a poor week, with Japan following suit. Hong Kong and mainland China bourses were in the minority for showing positive returns, buoyed by President Xi Jinping’s newfound pro-business tone.

Appropriately for an asset class that thrives on uncertainty, gold was the standout, with the spot price hitting a record high. Gold is up 12% year to date and almost 50% in the past 12 months.^[1] 

War of the Words

President Trump and Ukrainian President Zelensky engaged in a war of words last week, following US-Russia talks in Saudia Arabia to end the latter’s war with Ukraine. Representatives from Ukraine and other European governments were not invited to the talks.

In the days that followed, Trump referred to Zelensky as a dictator and even claimed Ukraine started the war, despite all evidence to the contrary.^[2] Zelensky said Trump was “living in this disinformation space”.

Global political leaders have been wary of publicly criticising Trump or his administration since his second term began. One voice who did speak out against Trump’s comments was German Chancellor Olaf Scholz, who said: “It is simply wrong and dangerous to deny President Zelenskyy his democratic legitimacy. Ukraine has been defending itself against a merciless Russian war of aggression for almost three years.”^[3]

As we saw during his first term and have seen more evidence of second time around, Trump’s position on issues is rarely set in stone. His tirade against Zelensky came just days after reports that the US administration had offered Ukraine a deal: American troops to provide security against Russia in exchange for 50% ownership of Ukraine’s rare earth minerals.^[4]

Common ground

Of course, Trump’s position could change again. One consequence of his somewhat combative rhetoric towards Europe, possibly intentional, is that the region’s approach to military spending —a perpetual US bugbear — will finally change. Military spending by EU member-states has increased more than 30% in the past 4 years to €326 billion (around 1.9% of EU GDP).^[5] But that total is dwarfed by the US$916 billion spent by the US.^[6]

Last weekend, regional leaders convened a security summit in Munich to discuss future defence commitments. NATO Secretary General and former Dutch Prime Minister Mark Rutte said EU NATO members would need to boost spending by “considerably more than 3 percent” of GDP,^[7] while European Commission President, Ursula von der Leyen, proposed to relax the EU’s strict fiscal rules to substantially increase member states’ defence contributions.^[8]

One option could be for EU countries to raise funds via common bonds, already an established part of the bloc’s financing toolkit. In an interview with Bloomberg, EU foreign affairs and security policy chief Kaja Kallas said common bonds would enable the region to raise finance fast, while adding that the bloc could also use unallocated capital from a recovery fund set up during the COVID-19 pandemic.^[9]

Expectations for a material increase in EU defence spending had an immediate impact on government bonds, particularly at the long end. UK gilts were part of that move, while also responding to higher-than-anticipated inflation in January, as the Consumer Prices Index including owner occupiers' housing costs (CPIH) rose 3.9% in the 12 months to January 2025, up from 3.5% in December 2024.^[10]

Also contributing to the underperformance of European government bonds last week were comments made by ECB monetary policy committee member Isabel Schnabel on future rate cuts. In an interview with the Financial Times, renowned hawk Schnabel said the central bank should start the debate on pausing or halting further cuts.^[11]

After welcoming 5 cuts to the ECB’s key policy rate since June 2024, from 4% to the current 2.75%,^[12] markets had expected a continuation in the ECB’s approach until rates fall to 2% (or lower) given Europe’s weakening economic outlook. Any possibility of a pause or halt to proceedings could have negative implications for the economy and for financial asset prices.  

Although European investment-grade was the worst-performing credit sub-asset class, investors were not deterred from participating in primary deals or allocating to dedicated IG bond funds. It was the biggest week so far this year for inflows, with €1.2 billion of capital going into IG bond funds—3 times the historical average—while the €25 billion of supply by corporate and financial borrowers was the second-largest week for new IG issuance.^[13] There was little in the way of new issue premia, with the average oversubscription level of 4 times highlighting the strength of demand.

The guy who came in from the cold

Almost five years ago, in the ultimate strongman act, President Xi Jinping showed Chinese billionaire and Alibaba Group co-founder Jack Ma who was boss by pulling the plug on the planned IPO of Ma’s digital payments company, Ant Group, before launching a major crackdown on China’s tech sector.^[14] Since that move, which followed Ma’s criticism of China’s financial regulators, Ma largely disappeared from public view.

But time is a healer, as they say. In a sign of a thawing in relations, Xi welcomed Ma, along with other tech business leaders, including man of the moment, DeepSeek founder Liang Wenfeng, to a meeting in Beijing last week.^[15] Xi urged attendees to “maintain their competitive spirit and have confidence in the country’s future”, while promising to “abolish unreasonable fees and level the competitive playing field”.

The meeting was the latest evidence of Beijing’s efforts to revive the Chinese economy, which have assumed even greater importance given the threat of an escalation in the US-Sino trade war, a hallmark of Trump’s first term.

Local markets reacted positively to the softening in the government’s tone towards private enterprise. Year-to-date, the Hang Seng Tech Index, which tracks the performance of the 30-largest tech companies listed in Hong Kong, has soared over 30%.^[16] This compares to a more modest 3.5% by the tech-dominated Nasdaq Composite Index.

Technology may not be the only battleground where Xi is prepared to show strength against the US. According to recently published data by the US Treasury, China offloaded US$57.3 billion of US Treasury securities in 2024,^[17] bucking the trend of many major countries that added significantly to their holdings (See Chart of the Week). 

Chart of the Week: Japan and China offload US Treasuries

Source: US Treasury, ‘Major holders of Treasury Securities,’ February 18, 2025. For illustrative purposes only.

Past performance is not a reliable indicator of current or future results.

References

[1] Bloomberg, Gold spot rate, as of February 21, 2025
[2] BBC, ‘Trump tells BBC that Russia has 'the cards' in peace negotiations,’ February 20, 2025
[3] Politico, ‘Trump’s Zelenskyy tirade proves too much for European leaders to stomach,’ February 20, 2025
[4] NBC, ‘Trump officials pitch Zelenskyy on U.S. owning 50% of Ukraine's rare earth minerals,’ February 15, 2025
[5] Consilium, ‘EU defence in numbers – Consilium,’ January 28, 2025
[6] Peterson Foundation, ‘The United States Spends More on Defense than the Next 9 Countries Combined,’ April 2024
[7] Politico, ‘Rutte: NATO spending target will be ‘considerably more than 3 percent,’ February 15, 2025
[8] The Guardian, ‘Why Europe’s defence spending may need a bold new approach,’ February 20, 2025
[9] Bloomberg, ‘EU’s Top Envoy Says Common Bonds for Defense Are on the Table,’ February 19, 2025
[10] Office for National Statistics, ‘Consumer price inflation January 2025,’ February 19, 2025
[11] Financial Times, ‘ECB’s Schnabel calls for debate on ‘halt’ to rate cuts,’ February 19, 2025
[12] European Central Banks, ‘Key ECB interest rates,’ as of February 2025
[13] JP Morgan, ‘European Credit Fund Flows: Weekly Update,’ February 21, 2025
[14] CNN, ‘China halts Ant Group’s giant IPO after dust up with billionaire Jack Ma,’ November 3, 2020
[15] Bloomberg, ‘Xi Voices Support for Jack Ma, China Private Sector Chiefs,’ Bloomberg News, February 17, 2025
[16] Hang Seng Index, ‘Hang Seng Tech Index,‘ as of Feb 19, 2025
[17] US Treasury, ‘Major holders of Treasury Securities,’ February 18, 2025

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies are for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of February 24, 2025, and may change without notice. All data figures are from Bloomberg, as of February 21, 2025, unless otherwise stated.

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