Eurozone economic outlook – cyclical upswing, but structural problems remain

The Eurozone economy is staging a comeback following a prolonged period of stagnation. But the new dichotomy has been born, with some regions such as Spain and Italy enjoying renewed economic activity, while the typically strong economies like Germany and France grapple with structural and manufacturing issues.

This article explores the diverse economic conditions across the bloc, highlighting both the opportunities and the persistent hurdles that the continent faces.

How is Europe faring?

Europe is on a cyclical upswing as consumption across the continent is picking up. People feel more confident about spending as inflation eases and credit becomes more accessible – thanks to lower interest rates. However, the uptick in consumption is unlikely to be spectacular one.

In the medium term, fiscal and monetary stimulus from governments and the central bank will be needed. But to really get long-term growth back on track and meet consensus expectations, structural changes are crucial, especially in Germany – where the economic model continues to struggle and is facing a crisis.

Inflation is pretty much on target right now at 2.2%. Food prices are still a bit high, though they are starting to come down. Energy costs have recently risen which is likely to be seasonal. That said, Europe’s reliance on importing energy is a risk if geopolitical tensions continue to rise. Core inflation is being stubborn, like in many other major economies, because services are still pricey, but we expect this to ease off over the next year.

The labour market has remained solid. Wages are growing enough to give people real income gains and are in line with the inflation target. Based on the above, this should give the European Central Bank (ECB) enough confidence to push on with interest rate cuts.

Investment took a hit due to a credit squeeze but should bounce back now that interest rates are being cut. Industrial production is set to benefit from the upswing, but full recovery will need more structural reforms. Plus, the ongoing trade dispute with China, and possibly the US after the outcome of the election (if Donald Trump regains the keys to the White House), is another hurdle for the EU industry.

The role of the European Central Bank (ECB)

The ECB was the first major Western central bank to start the rate cutting cycle due to a benign inflation outlook and slow growth. In our view, the ECB is in a good position to continue with a series of steady and regular rates cuts over the next 12 to 18 months.

Given the political and economic diversity within the Eurozone, centralised fiscal stimulus is unlikely, making monetary policy adjustments a critical lever for economic management. As such, rate cuts are one of the few policy moves that would benefit most, if not all, the Member States. As European firms get a much higher share of their financing from floating rate bank loans, rather than capital markets like their US and UK counterparts, the effect of cuts should be felt in Europe sooner.

Cutting interest rates would also likely weaken the Euro. Both Germany and Southern European economies could benefit from this as it would make exports more competitive. However, this comes with the risk of imported inflation, which could erode purchasing power and savings.

The Germany question

Germany, often seen as the economic powerhouse of Europe, faces its own set of challenges. The country is at a crossroads, needing significant structural reforms to maintain its economic leadership.

Germany has been here before. The early 2000s saw Germany implement significant labour market and welfare reforms, known as the Hartz reforms, which began to show positive results in the early 2010s. If a similar timeline is followed, any new reforms introduced post-2025 election would likely bear fruit by the 2030s at the earliest.

France’s deadlock

France, Europe’s second-largest economy, is in a state of political and economic deadlock. The country faces high public debt, labour market reform-related protests, and slow economic growth. Political fragmentation have made it difficult to implement necessary reforms.

The southern economies

While France and Germany struggle, Spain, Italy, Greece and many other formerly struggling economies are performing well. NextGen EU funds have kickstarted growth, despite some setbacks with disbursements, and inflation has eroded the debt burden of many countries.

As many of these economies are more services reliant, particularly tourism, the outlook remains solid.

The green transition issue

Europe’s energy policy has been a contentious topic. The ambitious shift towards renewable energy and ‘net zero’ has faced criticism for being misguided and poorly executed. This transition has led to higher energy costs, impacting both consumers and industries. EU electricity is two-to-three times more expensive than in the US and gas is four-to-five times the price. This places many EU businesses at a big competitive disadvantage and is leading to job losses and closures.

Moreover, Europe’s automotive industry, a cornerstone of its economy, has been caught off guard by the rapid advancements of Chinese electric vehicle (EVs) producers. The Germany economy has felt the full force of this. The EU took the decision to place high tariffs on Chinese EVs to make them less attractive and to slow their entry into the market. The ongoing trade dispute is likely to face some sort of retaliation from China. In the short term, this will be negative but could prove a boost to domestic producers in the medium to long term.

Read more: Draghi unveils EU competitiveness plan

The bottom line

The macroeconomic outlook for Europe has improved on the whole with growth trending upwards. However, for Europe to achieve sustainable growth over the long term, it must address its structural challenges.

Germany needs to lead by example, implementing reforms that can be a blueprint for other countries. The ECB must carefully balance monetary policy to support growth while managing risks that inflation reaccelerates. The continued war in Ukraine, possible trade wars with the US and China, and conflict in the Middle East are likely to provide headwinds to growth in the near term.

Considering the balance of risks, we prefer our asset allocation exposure to Europe to be split between large global names and more domestically oriented smaller companies.