Europe’s Economic Future: A Stable Base in a Volatile World

Europe’s economic prospects look lacklustre amid structural challenges, but institutional progress, better policy coordination, and stronger political cohesion provide a stable backdrop for investors. With steady interest rates and a resilient credit market, the region offers attractive opportunities for those seeking diversification and dependable returns in an uncertain global landscape.

In our recently published Secular Outlook, we argued that a fragmented global economy combined with elevated public debt levels will create an environment of high macroeconomic volatility, with risks generally skewed to the downside.

Europe is no exception. Domestic and external challenges mean that Europe’s macro outlook will remain subdued, with growth potential slowing from around 1% pre-pandemic to around 0.5% over the next five years. This slowdown is driven by weaker demographics and slower productivity growth, according to our analysis. The weak productivity outlook reflects ongoing challenges such as a lagging position in the global technology race, intense competition from China, and elevated energy prices compared with the pre-Ukraine war period – all compounded by a less favourable global trade environment (see also our recent note on EU-U.S. trade relations).

The shift in German fiscal policy toward higher defense and infrastructure spending is significant. However, we do not expect this to extend across the region, as other major countries such as France, Italy, and Spain are unlikely to increase unfunded spending due to debt sustainability constraints. Additional defense spending outside Germany will likely be offset to a large extent by spending cuts in other areas. On balance, we expect a broadly neutral fiscal stance across the euro area over the next five years.

On the nominal side, inflation is unlikely to return to the 1% level seen in the years before the pandemic, given deglobalisation pressures and somewhat higher inflation expectations. Still, we expect inflation to settle below the European Central Bank’s 2% target. The weak growth and inflation outlook will continue to anchor equilibrium policy rates, which over time are likely to fall below the current nominal level of 2% suggested by our models.

Resilience across the region

As bleak as this may sound, there’s a silver lining: We expect the monetary union to remain stable over the secular horizon. The region has passed significant stress tests in recent years – including a pandemic and a war – demonstrating strong political commitment to unity. This resilience has been supported by meaningful institutional progress, such as the ECB asserting its role as a reliable lender of last resort for sovereigns (through various asset purchase programs and tools addressing sovereign stress), as well as improved fiscal cooperation via cross-border fiscal transfers funded by the pandemic-related Next Generation EU program. While Next Generation EU is intended as a one-off, it offers a potential template for future downturns.

Today’s political landscape also appears less disruptive. Although populist pressures remain alive and well, with far-right parties either in government or gaining support, true Euro-skepticism aimed at dismantling the EU and the monetary union has faded. For example, perceived risks over the election of a far-right government in Italy quickly dissipated as the administration adopted moderate economic policies. Support for the euro is currently at record highs, and political commitment to cohesion may strengthen further amid a more adversarial global political environment.

That said, risks remain. We are monitoring France closely due to a steeply rising debt-to-GDP path, challenges in implementing spending cuts, and an already very high tax-to-GDP ratio. Still, some fiscal adjustment is ultimately likely, and we would view this as more of an idiosyncratic French risk premium issue than an existential risk for the region.

Investment implications: Rates and FX

The challenged growth outlook and subdued inflation environment we expect suggest that European duration valuations should remain stable, with Bunds likely serving as a good diversifier in portfolios. Additionally, increased demand for European safe assets – driven by global diversification away from the U.S. – could further support duration.

The theme of steeper curves mentioned in PIMCO’s Secular Outlook also applies to Europe. Rates at the front end and the belly of the curve should remain anchored by low equilibrium policy rates, while long-end yields are likely to be held up by higher German issuance.

The stability of the monetary union should result in relatively stable sovereign spreads over Bunds, enabling investors to earn additional yield by buying a diversified basket of euro area sovereign bonds. The line between core and periphery countries is also becoming more blurred, so investors should choose sovereigns based on relative fundamentals rather than traditional bucketing.

Regarding currencies, we do not see the U.S. dollar’s role as the global reserve currency being challenged. However, global diversification could prove a modest tailwind for the euro.

Investment implications: Corporate credit

In the high quality investment grade credit space, the €4 trillion+ European market offers abundant opportunities to invest in issuers that have been tested over multiple economic cycles and are well-accustomed to operating in a low growth environment. Given the region’s muted GDP growth, many high quality corporates have typically adopted relatively conservative balance sheet strategies, providing ample financial flexibility to successfully navigate a range of macroeconomic scenarios. Active management is key to finding such select opportunities.

The European investment grade market also benefits from the embedded diversification provided by duration which, at around five years, is anchored around where we see the most compelling risk-adjusted returns. Within the global credit universe, the lower interest rate sensitivity of the European credit market has contributed to its lower volatility in recent years, positioning it advantageously amid an environment of steeper yield curves.

Outside of investment grade, the European high yield bond market has significantly improved in quality over the past 15 years, with over 65% of the market now rated BB. During this period, European high yield has delivered returns comparable to the European equity market but with markedly less volatility. As equity valuations continue to richen, credit has the potential to outperform again over the secular horizon but with only one-third to one-half of the volatility.

Finally, European credit could naturally benefit from increasing numbers of investors seeking diversification away from U.S. credit, which is overwhelmingly concentrated in U.S. corporates.