European stocks look set to benefit from reflation, but heavier bond supply and tighter investor demand are likely to push yields higher.
December 2, 2025
By Frédérique Carrier; Rufaro Chiriseri, CFA; Thomas McGarrity, CFA
Europe is facing opposing macroeconomic forces. On one hand, U.S. tariffs and a strong euro are squeezing the export sector, while Chinese competition is intensifying. Countries such as Germany and Italy, with their large industrial export sectors, are pinched the most.
On the other hand, powerful forces are providing a reflationary lift: loose monetary policy, with the European Central Bank (ECB) having cut its benchmark interest rate in half to two percent since mid-2024; expansionary fiscal policies in some countries, with Germany’s 10-year €500 billion infrastructure programme being the highlight; and the implementation of structural reforms.
Overall, we believe evidence points to domestic reflationary forces winning. After all, the eurozone region has been growing modestly, beating slower-growth market expectations, and export-exposed countries seem to have avoided recession in 2025. RBC Capital Markets has penciled in 1.5 percent growth for the region in 2026 as Germany’s infrastructure investment and defence spending are expected to contribute in earnest.
Progress on structural reforms could underpin growth further. The European Policy Innovation Council found that only some 11 percent of former ECB President Mario Draghi’s 383 recommendations for reform have been fully implemented. A year ago, he urged EU leaders to address the bloc’s ongoing productivity shortfall by deepening the single market, boosting innovation and diversifying supply chains.
Much remains to be done. Unfortunately, political instability in France could hold back progress. Discussions of common borrowing to fund defence and scientific research, as Draghi had suggested, will be hard to advance so long as the EU’s second-largest economy has not put its public finances in order. Any delay in the implementation of Germany’s infrastructure plan would also limit growth prospects.
The graph details four stages of implementation reached for each of Mario Draghi’s 383 reform recommendations (data as of September 4, 2025). The implemented category shows 11%; partially implemented 20%; in progress 46%; and not implemented 23%.
Source – European Policy Innovation Council (EPIC), RBC Global Asset Management
The STOXX Europe 600 ex UK Index – our preferred proxy for eurozone equities – trades at 14.8x 2026 consensus earnings estimates. That is slightly above its long-term average, a premium we believe is warranted given the region’s fiscal impulse is improving the medium-term growth outlook.
We continue to prefer sectors we think are likely to benefit from fiscal stimulus, such as select Industrials, including defence, and Materials. In our view, banks should benefit from the region’s improved medium-term growth outlook, while continuing to provide attractive dividends and share buyback opportunities.
Our base case forecast calls for eurozone GDP growth of 1.6 percent in 2026, boosted by increased regional fiscal expenditures, notably the loosening of the German fiscal brake and €500 billion in infrastructure spending that Germany is planning over the next decade. This should lead to a modest uptick in inflation, keeping the European Central Bank’s (ECB) monetary policy rate at two percent. The risks to our base case are tariff headwinds and delays in fiscal spending, which could suppress economic growth and ultimately lead to inflation undershooting the ECB’s two percent target over the medium term.
Germany has the fiscal headroom to borrow, while France’s unpredictable political backdrop makes fiscal tightening seem like a tall order. French sovereign bond yields are likely to remain at or above Italian yields. On the other hand, Italy is on track to potentially exit the EU’s excessive deficit procedure by 2026. Elsewhere, we think the fiscal deficits of Spain, Portugal and Greece are likely to remain well controlled and these nations’ sovereign bonds should outperform in a competitive yield environment. With increased overall bond supply and our expectation that yields will trend higher in 2026, especially in Germany, we prefer an Underweight position in European sovereign bonds.
The chart, as of November 6, 2025, illustrates the current yield curve of German Bunds and the market’s projected yield curve for one year ahead, across maturities ranging from 1 year to 30 years. The market projections for the yield curve across all maturities are consistently higher than the current yields. The largest difference between current and projected yields is observed in the 3-year maturity category, with a current yield of 2.02% expected to rise to 2.24% one year from now, a difference of 0.22%. The smallest difference is found in the 30-year maturity category, where the current yield of 3.20% is projected to increase to 3.30% one year ahead, a difference of 0.10%.
Source – RBC Wealth Management, Bloomberg; data as of 11/6/25
In corporate bonds, we forecast modest widening of investment-grade credit spreads – the additional compensation for credit risk – and a more pronounced widening in high-yield spreads. While high-yield bond default rates have fallen from cycle peaks and stabilised, we project an uptrend in defaults in 2026 driven by idiosyncratic factors. Investors’ ongoing robust demand for yield and fiscal expansion should remain supportive for credit spreads, and we expect the high-yield sector to outperform the investment-grade space. Within investment-grade, we think opportunities remain in the Autos sector due to attractive valuations versus historical averages and relatively strong balance sheets. For similar reasons, we think there are compelling opportunities in the Telecoms, Utilities and Financials sectors.
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