Europe at a crossroads: a delicate balance of growth and risk

As Europe navigates a shifting global landscape, the EU faces mounting pressure to assert its role between a protectionist U.S. and an expanding China. While 2024 closed with sluggish growth, forecasts for 2025 are more promising, with a slight pick-up in activity, stabilising inflation, and resilient private consumption expected to drive growth. Meanwhile, political risks in France and Germany and continent-wide fiscal challenges could shape market sentiment and economic momentum. With markets carefully assessing these risks, Europe's ability to reinforce its economic resilience will be crucial in the year ahead.

The EU finds itself caught between a rock and a hard place, navigating between a protectionist U.S. administration and China, with a growing impetus to find a unified voice. Despite typically underestimating its own global standing, a survey conducted by the European Council on Foreign Relations in collaboration with the University of Oxford across several countries showed that 55% of respondents considered the EU as a power capable of dealing on equal terms with the U.S. and China, and 71% viewed it as an ally or a necessary ally.

Despite rising concerns over the severity of Trump’s trade policy, European exports, which had lagged due to expanded Chinese competition, are now expected to pick-up slightly. The EU's ability to leverage its internal market strength and trade diversification will mitigate worst-case fears about the U.S.’ tariff threats.

The EU has now several tools to retaliate efficiently if needed including targeted tariffs to hit certain US industries and states and this arsenal has improved substantially since the first Presidency of D. Trump (anti-coercion instrument, etc).

However, tariffs will hurt if fully and permanently implemented. A hostile trade war (A 10% tariff hike could reduce output in the euro area by around 0.5% after 1 year and -1% after 3 years), so Europe needs unity to manage an increasingly unpredictable US administration.

The macro-environment underpins Europe’s ability to consolidate. Despite a weak end to the year (Q4 GDP growth was near zero), forecasts for 2025 remain constructive, with trade and private consumption expected to drive recovery. Private consumption faltered in 2024, with high savings rates offsetting rises in real disposable income. However, with the savings rate expected to drop a little, increasing real incomes can translate to higher spending.

Meanwhile, inflation nears the ECB's 2% target, with sticky services inflation expected to ease, allowing for rate cuts until June and a terminal rate at 2%. Long-term rates will likely remain stable due to market pricing, low recession risk, and ongoing quantitative tightening, with 10-year rates expected to remain close to current levels (2.2% for 10-year swap and 2.4% for Bund 10-year).

Looking at the FX market, following a recent spike in the wake of tariff announcements, the Dollar is expected to enter a period of stability in 2025 after reaching 40-year highs. While the Euro has underperformed the Dollar, it remains strong against other global currencies, notably the Chinese Yuan, Scandinavian and emerging market currencies. Eurozone growth and U.S. trade policy developments look set to support Euro appreciation.

Across the continent, however, political risk lurks under the surface. In France, the prospect of snap elections as early as summer adds uncertainty that could weigh on growth. While GDP held at 1.1% in 2024, as in 2023, business surveys suggest a loss of momentum for the French economy, with strong services growth offset by France’s comparatively weak manufacturing sector.

Private investment and unemployment are key concerns for 2025. Business confidence declined at the turn of the year, with investment in manufactured goods feeling the worst of the effects. Meanwhile, unemployment rate is expected to hit 8% by year-end, highest since mid-2021. The government must be alert to these risks in the coming months.

There are reasons for cautious optimism, however. Market risks are already priced in, and France's strong fundamentals – a large, diversified economy, favourable demographics, and solid institutions compared to its neighbours – offer resilience. There may be risks on the horizon, but France is well-placed to tackle them.

Germany faces a pivotal 2025 election, with the CDU/CSU currently leading the polls over the far-right AfD at 30% and 21%, respectively. Any alliance involving the AfD is unlikely, so it’s up to the CDU/CSU to form a workable coalition with either the SPD or Greens, ideally avoiding a dysfunctional three-party government.

Germany’s ability to recover to pre-pandemic levels hinges on structural reforms – reducing bureaucracy, addressing energy costs, and boosting investment. The CDU/CSU’s electoral lead suggests a stable coalition scenario, but its ability to push growth-friendly reforms will be key to maintaining investor confidence.

Budgetary concerns will be at the forefront of European economic policymaking, with countries such as France, Italy and the UK looking to manage their increasing debt levels. France and Italy are both forecast to improve their primary balance over the coming years. However, while Italy’s relative stability points to a future surplus, France’s uncertain political landscape means it cannot expect such fortunes.

The UK faces a similar challenge to France and must focus heavily on its fiscal situation. The government announced spending plans of 2.2% of GDP annually, supported by tax revenue increases of 1.1% of GDP and higher borrowing. According to the Office of Budget Responsibility (OBR), there will be short-term pain, with private consumption and business activity declining until 2030 and borrowing costs increasing in tow.

In response, the Bank of England will adopt looser monetary policy to boost market confidence and stimulate business activity (4 rate cut expected this year), frontloading four rate cuts this year. With UK debt projected to rise to 106.1% of GDP by 2030, investor sentiment remains cautious. The Bank of England’s monetary easing aims to counteract near-term consumption declines, but uncertainty over fiscal headroom could weigh on the UK’s credit rating and borrowing costs.

Despite political unrest, Europe's real estate market continues to show resilience. The eurozone housing market appears to be bottoming out, with prices rebounding 1.9% in Q2 2024 after a 1.4% year-on-year rise.

Germany and France have seen a gradual decline in housing prices over recent years, but that contraction has begun to moderate, with French prices stabilising and Germany seeing two-quarters of consecutive growth at the end of 2024. Spain and Italy avoided some of these challenges, with strong economic fundamentals, a healthy labour market and supply constraints supporting their housing markets.

The resilience of the real estate sector underscored broader stability in Europe assets, which is also reflected in equities. Despite structural weaker earnings growth and profit margins compared to the U.S., European stocks remain attractive in the short to medium run as i) they are  cheap (vs US equities), ii) they should be supported by a weak EUR, a rebound in Chinese activity and a dovish ECB, iii) portfolio managers seek to diversify away US equity risk, as Us indices are expensive and extremely concentrated into the Magnificent 7. The recent DeepSeek episode should reinforce the later.  

Europe enters 2025 at a crossroads. While economic indicators point to a gradual recovery, political uncertainty and fiscal constraints remain significant risks. The political landscapes of France and Germany will influence investor confidence, and budgetary discipline will be critical for long-term stability. Despite lagging U.S. corporate growth and margins, European equities provide diversification opportunities (especially vs expensive US equities), and the real estate market is proving resilient. With a measured approach to policy and economic reform, Europe has the potential to establish itself as a stable and influential global player.