Table of Contents

Foreword 2

Executive summary 4

1. The euro area in a volatile world: resilience under strain 6

Key takeaways 6

1.1 Setting the scene: the euro area in a fracturing global order 7

Box 1.1. Which news moves euro area financial markets? 9

1.2 Risks to the euro area outlook: geopolitical tensions and fragilities in US financial markets 11

Box 1.2. Sovereign bond flows amid geopolitical risk and market volatility 19

1.3 Financial vulnerabilities as amplifiers of external shocks 22

Box 1.3. Banksʼ sovereign exposures and credit supply under a new geopolitical regime 25

Box 1.4. Analysing price sensitivity in euro area sovereign debt markets 30

1.4 The adverse scenario: geopolitical tensions persist in the Middle East and US asset prices adjust abruptly 32

1.5 Implications for sovereigns: large fiscal challenges ahead, manageable only over time and with market trust 36

Box 1.5. Results from the ESM Sovereign Sentiment Survey 44

1.6 Conclusion: resilience requires credibility 48

1.7 References 49

2. Security at what cost? Defence spending, growth, and the 昀椀scal arithmetic 53

Key takeaways 53

2.1 Introduction: Europeʼs changing geoeconomic landscape 54

2.2 The defence spending gap 55

2.3 Defence firms, supply chains, and productivity spillovers 57

2.4 Macroeconomic and fiscal impacts of the defence build-up 60

2.5 Conclusion: defence investment can partly pay for itself, if done right 67

Box 2.1. Lessons from past build-ups 70

2.6 References 72

Additional information 76

3.1 Abbreviations and acronyms 76

3.2 Acknowledgements 80