Euro area: an encouraging change of perspective

Recent developments highlight several reasons for a more constructive view of the euro area economy:

• Growth has been surprisingly resilient. Euro area GDP grew by 0.4% quarter on quarter (QoQ) in Q2 and 0.3% QoQ excluding Ireland, whose GDP data can be distorted by multinational activity. Despite significant geopolitical headwinds, growth in the first half of the year has broadly matched the region’s long-run average. (See Exhibit 1.)
• The recovery is broadening. Domestic demand has increasingly offset weakness in the external sector, while industry and construction are contributing positively again. Core economies such as Germany and France are beginning to play a larger role, alongside the stronger southern European countries (Spain, Italy, Portugal, Greece) that continue to outperform. Labour markets also remain supportive, with unemployment close to record lows, although hiring has slowed, while youth unemployment has almost halved from its 28% peak in 2013. (See Exhibits 2 and 3.)
• Germany moving up. Europe’s largest economy and long-time laggard has strung together three consecutive quarters of solid growth for the first time since 2017 outside the post-lockdown rebound, as firms adapt to a changed world while benefiting from a timely fiscal boost. The sharp rise in factory orders since autumn 2025 suggests Germany can move from the back of Europe’s growth peloton towards the front.
• Inflation remains elevated, but underlying pressures are still relatively contained. Headline inflation continues to hover near 3% and – on current energy futures – looks set to remain well above target well into 2027, yet services inflation and wage growth have not shown the kind of acceleration that would point to a sustained inflation spiral.

In summary, the “stagflation” narrative of high inflation and low growth is giving way to a more “reflationary” one: inflation remains elevated, but growth is proving resilient despite a challenging backdrop (albeit still running just below the pace of previous expansions).

This creates a clearer backdrop for the European Central Bank (ECB). The rationale for tighter policy has shifted from precautionary “insurance hikes” to a more conventional tightening cycle supported by underlying economic strength. We had already moved to a base case of two further hikes, in September and December, partly reflecting our revised Fed call (also two hikes this year). Recent domestic data reinforce that view.

For markets, a reflationary environment cuts both ways. It is typically supportive for equities, which tend to look through rate hikes when they reflect stronger growth rather than simply higher inflation (see our House View Update). European equities have shown resilience through the recent correction in overheated pockets of global markets.

The outlook for bond investors is more nuanced. Elevated inflation and higher rates remain near-term headwinds, particularly as a broader hawkish shift takes hold globally and structural forces such as AI investment and de-globalisation may be pushing neutral rates higher.

Yet Europe also retains an important medium-term advantage: the economy is still recovering from a series of shocks that left output well below its pre-pandemic trend. This is reflected less in unemployment than in productivity, which has lagged significantly behind the US (see Exhibit 4). In our view, that reflects labour hoarding and underinvestment rather than a deterioration in workforce quality. As these headwinds fade, a productivity rebound could allow the economy to grow above trend without generating materially more inflation.

The verdict on Europe’s neutral rate remains open. We do not expect the ECB to tighten beyond 2.75% and see scope for rate cuts again in 2028 once inflation returns to target. In that scenario, Europe could move closer to the “Goldilocks” scenario we envisaged at the start of the year: solid growth accompanied by lower inflation.