2025 ends on a good note
The euro area delivered an encouraging surprise in Q4 2025, with 0.3 percent quarterly GDP growth outpacing consensus expectations and driving full-year growth to a solid 1.4 percent despite persistent trade tensions and heightened global uncertainty. Germany, Italy, and Spain accelerated, suggesting underlying resilience across the bloc’s largest economies.
Lower rates, stronger banks, easier financial conditions
The European Central Bank’s (ECB) substantial 200 basis points (bps) of rate cuts since June 2024 have been instrumental in supporting growth. With inflation hovering around the ECB’s two percent target, we believe the deposit rate is likely to remain steady at two percent throughout 2026, though a persistently strong euro could pose a downside risk to price pressures.
Lower interest rates have spurred a recovery in bank lending, and banks are in a markedly stronger position to meet loan demand following a decade of heightened regulation and private sector deleveraging after the 2012 sovereign debt crisis. The continent’s top 18 banks are better capitalised, with a Tier 1 capital ratio averaging 13.7 percent, according to RBC Capital Markets.
Economic resilience was further supported by a narrowing of most sovereign bond spreads—the yield premium over German Bunds—which eased financial conditions. The widest major eurozone sovereign bond spread has compressed from over 150 bps two years ago to closer to 60 bps today, despite heavy sovereign issuance and the ECB’s balance sheet reductions. This spread compression reflects fiscal improvements in previously vulnerable economies, as well as increased investor confidence in the ECB’s role as a backstop and its institutional framework, which seems to be less susceptible to political interference than its U.S. counterpart.
Looking ahead, we think the momentum could well be maintained. The European Commission’s economic sentiment indicator reached its highest level in three years in January 2026. While most euro area economies will undertake fiscal consolidation in 2026, Germany’s €500 billion infrastructure programme announced in April 2025 is likely to support regional sentiment. The German government is projecting the federal budget deficit to widen from 1.1 percent of GDP in 2024 to a still enviably low 3.7 percent from 2026 onwards.
Overall, we expect a modest cyclical upturn in 2026, with RBC Global Asset Management recently increasing its 2026 GDP growth forecast for the eurozone to 1.8 percent, above the consensus level of 1.2 percent.
Europe in the new world order
U.S. President Donald Trump’s recent threats to annex Greenland, a Danish territory, and to impose punitive tariffs on European countries opposing the plan rattled Europe. As RBC Global Asset Management Inc. Chief Economist Eric Lascelles wrote, the Greenland saga “emphasizes that, in addition to being an unreliable trade partner, the U.S. is now an unreliable military partner … There is even the previously unfathomable risk that, as with Venezuela and Greenland, the U.S. could be the next adversary.”
Although the threats were withdrawn, they inflicted lasting damage on EU-U.S. relations. In response, European Commission President Ursula von der Leyen underscored the need for European strategic autonomy by deepening the single market, expanding the network of free trade agreements (FTAs), and bolstering security capabilities.
Strengthening the single market
Europe’s predicament may reinvigorate momentum behind the measures proposed by former ECB President Mario Draghi in 2024 urging EU leaders to address the bloc’s persistent productivity shortfall by deepening the single market, boosting innovation, and diversifying supply chains. While implementation has been slow, there has been some progress, with 15 percent of Draghi’s 383 reform proposals now fully implemented, up from 11 percent last September.
Against this backdrop, the EU has stepped up work on several targeted initiatives to strengthen the single market in practice. Issues to be discussed at a Feb. 12 summit include the proposed Industrial Accelerator Act, which would streamline regulations and boost investment across key industrial sectors, and modifying the regional emissions trading system to reduce the cost of doing business.
On the financial side, German Chancellor Friedrich Merz recently reiterated the need for progress on a capital markets union. In October 2025, Germany indicated its willingness to cede certain supervisory powers to the European Securities and Markets Authority—a significant departure from its longstanding opposition to EU-level regulatory centralisation.
A broad network of FTAs
Von der Leyen sees expanded FTAs as critical to strengthening Europe’s economic power. The EU recently concluded two landmark agreements after decades of negotiations, securing access to critical products, resources, and markets.
The pact with the Mercosur nations (Brazil, Argentina, Uruguay, and Paraguay) enhances access to critical minerals, diversifying Europe’s supply base. The FTA with India reduces tariffs on European cars from around 110 percent to just 10 percent for up to 250,000 vehicles annually. This could turn India, which imported just 10,000 cars from the EU in 2024, into a major auto export market.
Lascelles notes that both agreements represent meaningful steps towards trade diversification, though bilateral trade with Mercosur and India combined remains just one-quarter of EU-U.S. trade.
Security
Lascelles believes the Greenland episode has accelerated the military spending theme, with a pronounced pivot from within Europe that we anticipate will positively impact the EU economy. As Lascelles does not expect higher defence expenditures to be offset by cuts elsewhere, he anticipates a significant fiscal expansion ahead that could exceed consensus estimates. We note that eurozone public debt has returned to near pre-pandemic levels of some 85 percent of GDP.
Investing in Europe
Last year’s optimism following the announcement of the German stimulus has faded—perhaps overly so, in our view. We believe the impact of the German investment programme is now underestimated, as investors focus on structural challenges.
The MSCI Eurozone Index is trading at 16.3x 2026 consensus earnings estimates, a premium to its median valuation since 2003, though we view this as justified given the region’s improved economic momentum and earnings growth prospects.
Political risk remains in France but is likely contained until the 2027 presidential election. A strong euro poses a headwind to European exporters’ earnings, but this is likely to be offset by more buoyant economic activity.
Europe merits a Market Weight allocation within global portfolios, in our view. Beyond geographic diversification, we believe the continent presents compelling investment opportunities. We expect companies exposed to the German spending plan—particularly select Industrials, defence, and Materials—to do well. Banks are also attractive, in our view, supported by a steepening yield curve and improving loan demand, while trading at a valuation discount to their U.S. peers.