The outlook for the European economy is constructive. Economic growth remains sluggish but inflation has declined markedly. Labour markets are resilient while inflation-adjusted incomes have recovered from the recent energy shock. Our view remains that there are going to be gradual interest rate cuts going ahead. The European Central Bank is likely to cut benchmark interest rates by 100 basis points this year after a similar magnitude of policy easing in 2024.

However, the biggest risk facing the eurozone is a potential recession. Europe faces a 'perfect storm' of cyclical and structural headwinds. While interest rates are heading lower, they remain in restrictive territory. Moreover, the risk of escalating trade conflicts with the U.S. could undermine growth.

The EU is a much more open economic region than either the U.S. or China, with a total trade share of close to 45% of GDP, compared to around 35% and 25% for China and the U.S., respectively.¹ Given the importance of trade to the EU economy, the impact of higher tariffs imposed by its largest trading partner would be severe. These headwinds could exacerbate job losses and hit investor sentiment.

A lesser, but notable concern is the risk of stagflation which could dampen investor confidence. Recent inflation spikes in Germany and France indicate this risk warrants attention.

Economic diversity across the eurozone, however, offers some mitigation for these pressures. Peripheral economies, including Spain, Portugal and Greece, are witnessing growth rates that, in some instances, rival the U.S. Projections for these economies are being revised upwards, with accompanying rating upgrades. Bond yield spreads between peripheral and core eurozone government debt could tighten further.