The euro area defied expectations in 2025, delivering growth amid a challenging environment. Beneath this resilience Europe has started to redraw its economic and strategic maps—reducing reliance on the U.S. while capitalizing on fresh fiscal momentum from Berlin and a focus on defense.
The euro area delivered an encouraging surprise in Q4 2025, with 0.3 % quarterly GDP growth outpacing consensus expectations, driving full-year growth to a solid 1.4 % despite trade tensions and global uncertainty.
Germany, Italy, and Spain accelerated, 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 2 % target, the deposit rate is likely to remain steady at 2 % throughout 2026.
Lower interest rates have spurred a recovery in bank lending. Banks are in a stronger position to meet loan demand following a decade of heightened regulation and private sector deleveraging since 2012.
European banks are now better capitalized. Tier 1 capital ratios (amounts mandated by regulators that banks must put aside to support deposits), averaging 13.7 %, 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, (sovereign bond spread has compressed from over 150 bps two years ago to closer to 60 bps today).
Momentum could well be maintained. The European Commission’s economic sentiment indicator reached its highest level in three years in January 2026.
Most euro area economies will undertake fiscal consolidation in 2026. Germany’s €500 billion infrastructure program announced in April 2025 is likely to support regional sentiment. The German government is projecting the federal budget deficit to widen from 1.1 % of GDP in 2024 to a still enviably low 3.7 % from 2026 onwards.
RBC Global Asset Management recently increased its 2026 GDP growth forecast for the eurozone to 1.8 %, above the consensus level of 1.2 %.
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. Although the threats were withdrawn, they inflicted lasting damage on EU-U.S. relations. 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.
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.
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 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 % to just 10 % 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.
Both agreements represent meaningful steps towards trade diversification. South American and India combined remains just one-quarter of EU-U.S. trade. 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.
Many do not expect higher defense expenditures to be offset by cuts elsewhere. Eurozone public debt has returned to near pre-pandemic levels of some 85 % of GDP.
The MSCI Eurozone Index is trading at 16.3x 2026 consensus earnings estimates, a premium to its median valuation since 2003. This is 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 increased economic activity.
All thing equal - Europe merits a Market Weight allocation within global portfolio. Beyond geographic diversification, the continent presents compelling investment opportunities.
Expect companies exposed to the German spending plan—particularly select Industrials, defense, 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.
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