New and non-traditional rhetoric from the U.S. has galvanised European leaders. Defence spending has become a priority and this, along with a shift in German fiscal policy, should support growth. Despite the risks inherent in a trade war, we believe portfolios should be exposed to the region.
April 3, 2025
Frédérique Carrier Managing Director, Head of Investment StrategyRBC Europe Limited
Seismic changes are taking place in Europe. Prompted by signs that the traditional U.S. security support could be withdrawn or at least downsized, the German parliament recently passed landmark fiscal stimulus measures, a move which had eluded generations of lawmakers. The country is now poised to enter a new phase, in our view, moving beyond a period in which fiscal constraints stifled growth and undermined competitiveness.
The German fiscal package relaxes the limitation on structural deficits to allow for higher defence spending, a measure that effectively leaves defence spending unconstrained. It also creates a special fund for infrastructure investments of as much as €500 billion (or a sizeable 12 percent of annual GDP) over the next 12 years. Transport, hospitals and care, energy, education, digitisation, and R&D are all targeted.
It is notable that these measures were championed by chancellor-to-be Friedrich Merz, leader of the CDU/CSU party, who had recently campaigned on preserving fiscal restraint. His significant pivot points to the seriousness of both the situation and the commitment.
Meanwhile, the European Commission has proposed a plan to address deficiencies in the region’s defence capabilities by 2030, with recommended funding of up to €800 billion. This includes €150 billion of joint EU loans for defence investment and making defence spending by member states exempt from the bloc’s deficit rules.
Joint debt issuance has long been a contentious issue within the EU, and historically has been reserved for times of crisis such as the COVID-19 pandemic. Wealthier northern member states have been reluctant to subsidise their less-affluent neighbours, making such measures politically sensitive. The fact that joint issuance is once again being considered underscores the urgency of the current situation and suggests willingness to strengthen financial unity within the bloc may be growing. European Union leaders will now seek approval for the plan in their own countries.
These changes are occurring as the region’s domestic economy is picking up. RBC Capital Markets economists point out that real incomes have grown modestly as inflation has subsided. This and the delayed pass-through of the European Central Bank’s (ECB) cuts to outstanding mortgage rates should underpin a revival of consumption.
Economic activity indicators such as the HCOB Eurozone Composite Purchasing Managers’ Index are now narrowly in expansion territory.
The graph shows a quarterly breakdown of European Union GDP since Q1 2022 and three major contributors to it: private consumption, government consumption, and fixed investment. The data has been very volatile over this period. Private consumption played a very modest role from Q2 2023 to Q2 2024. Since Q3 2024, it has become a more important driver of economic growth. In Q4 2024, all three contributors had a positive impact on growth and since Q2 2024, the economy has grown consistently quarter over quarter.
Note: Ireland excluded due to volatile data.
Source – RBC Wealth Management, RBC Capital Markets, Haver Analytics, Eurostat
Germany’s fiscal package and the EU’s defence spending are also modest tailwinds. RBC Capital Markets economists calculate that Germany’s infrastructure spending, if ramped up over the next three years, could have a growth impact of 0.5 percent of GDP per year for the country, or 0.15 percent for the euro area. The impact could be larger in the near term if spending is front-loaded. Moreover, they estimate that increasing the EU’s overall defence spending to three percent of GDP in 2030 from the current 1.4 percent could have a direct impact of 0.3 percent per year on real GDP growth, on average, by 2030. However, they concede that this is an aggressive assumption, given that most Western militaries are already suffering recruitment challenges even before any additional spending.
RBC Capital Markets recently increased its overall eurozone GDP growth projections by approximately 0.5 percentage points per year, bringing anticipated GDP growth to 1.9 percent in 2026 and 1.8 percent in 2027.
The clear risk to these estimates is a trade war. RBC Global Asset Management Inc. Chief Economist Eric Lascelles maintains that the impact of tariffs on European economies is “unlikely to be too painful,” because unlike Canada and Mexico, Europe does not trade intensively enough with the U.S. The ECB had calculated that a 25 percent blanket tariff could crimp regional GDP growth by 0.3 percentage points over 12 months. Though the tariffs imposed by the White House are a little lower, at 20 percent, the impact on economic growth will depend on how long they are sustained, how the EU responds, and how badly the new trade policies hurt business and consumer confidence both in the region and globally.
Lascelles continues to believe that a deal will be struck eventually, and that lower, partial tariffs will end up being imposed, much like during the first Trump presidency – though this could take many months. In the meantime, the economies of the largest European exporters to the U.S. (including Germany and Italy) are likely to bear the brunt of impacts. The effect on corporate earnings should be relatively limited given that many companies have manufacturing operations in the U.S.
For now, we believe the new positive fiscal impulse in the euro area should offset the negative tariff impact, though we acknowledge the risk to growth may well be downwards.
The European Union’s structural issues, including a lack of investment by Germany, have been a key reason for global investors’ caution towards the European stock market. Recent developments suggest the bloc may be ready to tackle those issues, acting with urgency and cohesion. Reflecting this sentiment, markets have rallied year to date – but unbridled enthusiasm has given way to scepticism about implementation. Very large stimulus programmes come with risks, including timing challenges and the potential for misallocation of funds. Tariff worries are also weighing on regional equities.
Nevertheless, we believe that on a 6-to-12-month horizon, a Market Weight position in the region is now appropriate, up from an Underweight. This new positioning better reflects the improved outlook, while acknowledging that U.S. tariff developments could lead to volatility.
European equity valuations remain close to an all-time low relative to U.S. and global peers on a sector-adjusted basis. In our view, being selective and taking an active approach are crucial for this region, as it provides a rich and varied opportunity set for stock selection. We believe there are potential opportunities in Europe’s world-leading companies with structural global tailwinds, particularly in Technology, Health Care, and Industrials. We also see opportunities in niches exposed to the improving domestic picture and to areas targeted by new fiscal policies, including banks, defence, and capital goods.
With contributions from Thomas McGarrity, CFA
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