The euro area’s growth problem is well documented. Productivity has stagnated, demographics are deteriorating, and competition from China is intensifying.
AI could boost growth, while policymakers are gradually implementing elements of the 2024 Draghi report on the future of European competitiveness. Yet the outlook remains weak. We would be surprised if the euro area achieved annual growth of more than 1% over the next five years; more likely, it will grow by less.
Convergence and cohesion
Less appreciated, however, is how much more stable the euro area has become. Over the past few years it has weathered a series of major stress tests, including the pandemic, two energy shocks, and a sharp rate-tightening cycle.
In our recent Cyclical and Secular Outlooks, some of the key themes have been global divergence, fragmentation, and dispersion. But looking just within the euro area, many of the economic divergences that defined its first two decades have narrowed and instead we are witnessing convergence across a number of dimensions.
The result is a monetary union that still struggles to grow but is increasingly unlikely to break apart.
Convergence has occurred across three key dimensions:
- Growth. In the decade before the pandemic, northern countries consistently outperformed southern ones. This pattern has now reversed. Growth in once-troubled peripheral countries – Portugal, Italy, Greece, and Spain – has far outstripped that of Germany in recent years. GDP levels have started to converge, reducing one of the most visible imbalances within the currency union.
- Fiscal policy. Germany’s fiscal expansion is now well underway and, for the first time in almost two decades, the country is running a wider deficit than Italy and Spain. Germany’s debt-to-GDP is rising and, if current trends persist, could overtake Spain’s within the next decade. France’s debt trajectory remains a concern, as does Belgium’s, but across much of the euro area, debt dynamics look sustainable under current policies.
- External imbalances. Germany continues to run a current account surplus, but it is roughly half the size it was a decade ago. More importantly, Spain and Italy no longer run persistent current account deficits.
Improved policy infrastructure
This convergence partly reflects policy choices.
The Next Generation EU (NGEU) program launched during the pandemic set a precedent for cross-border fiscal support during downturns. The scheme is due to expire this year, although spending of the funds will likely spill over into next year. However, policymakers seem increasingly willing to use common issuance for other priorities, including defense and strategic investment.
The EU bond market has grown rapidly and is now one of the largest bond markets in the world. We do not expect the introduction of true eurobonds, whereby member states assume joint liability for each other’s debt. Even without joint liability, the current framework signals a greater willingness to share risks and strengthens perceptions of cohesion within the union.
At the same time, the European Central Bank’s policy evolution over the past 15 years has cemented the central bank’s stabilization role for sovereigns. Mario Draghi’s “whatever it takes” moment in 2012 was followed by the creation and implementation of a series of asset purchase programs. More recently, the ECB introduced its Transmission Protection Instrument (TPI) program, aimed specifically at preventing fragmentation and stress in sovereign markets.
Risks remain
While this convergence is positive, it is unlikely to remove all risks, as the euro area remains far from an optimal currency area.
Member states remain politically and structurally different. Labor mobility across countries is still far lower than between U.S. states, for example, and tax and spending decisions remain overwhelmingly national.
Some of the outperformance of peripheral economies in recent years is linked to NGEU-related spending, the effects of which are likely to fade from 2028.
Politics also remains a source of potential volatility, particularly with important elections next year in France, Italy, and Spain. Unlike a decade ago, however, there is little appetite among any major political party to leave the euro.
Despite these risks, the euro area appears significantly more stable than it did a decade ago, when the region faced its existential crisis.
Investment implications
Before the conflict in Iran, the ECB had broadly brought inflation back to target, and its 2% policy rate was widely viewed as neutral.
The renewed energy supply shock has caused it to start raising interest rates, and we currently expect no more than one additional hike beyond the one already delivered. Two hikes in total would bring the relevant policy rate to the upper end of its neutral rate range of 1.75%–2.5%.
More intra-euro area convergence and a stronger institutional framework should allow the ECB to worry less about fragmentation and financial stability risks, and focus primarily on delivering price stability through interest rates. This should reduce the risk of the euro area slipping back into the disinflationary environment that characterised much of the previous decade, while helping keep inflation expectations firmly anchored around 2%.
With central banks less involved in the bond markets, fundamentals matter again, and changes in the fiscal outlook are being repriced.
While euro area sovereign spreads have been tighter in the past, this may be the first period in which medium-term spread compression is justified by converging fundamentals.
As a result, we maintain a constructive stance on peripheral sovereigns, mainly through liquid market exposures such as Italy and Spain. In addition, we consider EU bonds an attractive high-quality source of potential carry for our portfolios.