Europe: Filtering out the noise

Economic resilience, policy shift

European corporate earnings were strong in Q2, with STOXX Europe 600 earnings per share excluding Energy rising a respectable 13 percent y/y, a notable performance given that energy shocks have historically dented European earnings.

In our view, strong earnings largely reflect a combination of domestic reflation and rising investment. The global AI infrastructure buildout, especially in the U.S. but also in Europe, has improved prospects of many global semiconductor and capital goods firms. Financials have benefitted from steeper yield curves and private sector releveraging, while Germany’s €500 billion infrastructure fund is beginning to filter through to construction and engineering order books. This all sits alongside a broader shift in European Union (EU) policy.

Squeezed between an unreliable U.S. trading partner and heavily subsidised Chinese industries, the EU has started protecting key industries, emphasizing strategic self-reliance over export-led growth. Steel import quotas, for instance, have already lifted European steelmakers’ Q2 earnings. In our view, this response to a distorted playing field could support economic resilience, though policymakers must guard against protection extending beyond what is strictly needed.

Overall, consensus expects GDP growth of 1.2 percent and 1.5 percent this year and next, respectively, while corporate earnings growth expectations have been upgraded to 15 percent y/y in 2026, and nine percent y/y in 2027.

Keeping watch on natural gas prices

Against the backdrop of economic resilience, the European Central Bank (ECB) has raised interest rates in September, following inflation that had reached 3.3 percent y/y in August.

Going forward, we expect the central bank to focus on how higher natural gas prices feed into broader inflation. Europe relies heavily on natural gas which also sets electricity prices. This gives the fuel a far wider inflation pass-through than oil, according to RBC Capital Markets.

Recently, natural gas prices have risen above €80/MWh, or more than double the pre-Iran-war level before retreating somewhat. Middle East uncertainty continues to impair liquefied natural gas shipping, with storage levels also low ahead of winter.

Markets are pricing in four more hikes by July 2027. In our view, the ECB will aim to keep this inflation spike short-lived. If successful, it could reverse course on interest rates later next year.

European wholesale natural gas prices have doubled since the Middle East conflict started

Euros per megawatt-hour

Note: The chart uses the TTF, or Title Transfer Facility, a virtual trading point for natural gas in the Netherlands, as a proxy for European wholesale natural gas prices.

Source – RBC Wealth Management, Bloomberg; data range 9/24/21–9/23/26

Noise ahead

The region is entering a period of political and fiscal uncertainty. France’s budget bill is due before Parliament by Oct. 6. So far, negotiations are highlighting the country’s reluctance to rein in social spending, even as subdued economic growth makes debt of close to 120 percent of GDP harder to sustain. The government now expects the fiscal deficit to reach 5.4 percent in 2026, up from 5.1 percent in 2025 and well above the EU’s three percent reference level.

Profligacy is a problem for France, whose borrowing costs now exceed Italy’s. It is now also an EU issue, given France is its second-largest economy. The French lack of fiscal discipline is complicating the case for EU joint borrowing, a route the bloc last took during the COVID-19 pandemic when it issued €750 billion in common debt. Germany and the Nordic states are reluctant to further joint borrowing, wary that it could leave fiscally stronger members effectively underwriting the debts of less disciplined ones, such as France. Joint borrowing matters to the bloc because it could fund large-scale shared priorities, such as defence, more efficiently than fragmented national efforts.

French presidential elections, to be held as a two-round vote next April and May, are likely to add to investor unease, in our opinion. Polls currently put Marine Le Pen, of the populist National Rally party, far ahead in the first round. Even though she has tempered her anti-euro rhetoric over the past few years, Le Pen would be unlikely to support further EU integration should she win.

In our view, investors will also follow with interest the impact of the recent landslide win of the AfD, a hard-right party, in two East German states. AfD supports normalizing economic relations with Russia, and is anti-immigration. The wins are unlikely to alter federal decision-making day to day, in our view, but the risks are that Germany Chancellor Friedrich Merz’s political position becomes even less secure, and it weakens the federal government’s reform programme somewhat.

National votes are also due in several other European countries. Italy, the bloc’s third-largest economy, must hold elections by December 2027. Prime Minister Georgia Meloni has moved towards the centre once in office, favouring fiscal discipline and softening her Eurosceptic rhetoric. She is also feeling pressure from the National Future party, a Eurosceptic party positioned to her right, that has drawn defectors.

The rise of populist forces in Europe’s largest economies is a trend worth monitoring, even as its near-term policy impact looks limited.

Volatility brings opportunity

Political risks will surely make headlines over the coming months, in our view, but the European corporate sector has accumulated a lot of experience at navigating uncertainty over the past 100 years. Moreover, companies on the STOXX Europe ex UK derive more than 50 percent of sales from non-European sources. Finally, inflation, fiscal, and political risks are well known and at least partially discounted by markets, in our assessment.

European yields reached multi-year highs in September. Moreover, the spread (difference) between French bond 10-year yields and German Bund 10-year yields reached 105 basis points, a decade high. While much of the French fiscal and political risk seems to be discounted, we expect the worsening deficit to keep this premium elevated. We prefer Spanish, Portuguese, and EU bonds. We believe 10-year Bund yields beyond 3.4 percent is an attractive entry point.

As for equities, we continue to rate European equities Market Weight. At 14.8x the 2027 consensus earnings forecast, we believe European equities offer broad appeal, particularly to investors who worry about a potential fading of the AI story in the United States. The asset class remains under-owned globally by institutional and individual investors, and we would use periods of volatility to build positions. We continue to like Industrials supported by various structural tailwinds.