Europe’s economic future: a stable foundation in a volatile world
11 AUG, 2025
By PIMCO
Author: Nicola Mai, economist, and Saurabh Sud, portfolio manager, from PIMCO
The economic outlook for Europe seems discouraging amid structural challenges, but institutional advances, better policy coordination, and greater political cohesion provide a stable environment for investors. With stable interest rates and a resilient credit market, the region offers attractive opportunities for those seeking diversification and reliable profitability in an uncertain global landscape.
In a recent report (Secular Outlook) we argue that the fragmentation of the global economy, combined with high levels of public debt, will create an environment of high macroeconomic volatility, with risks that, in general, point downwards.
Europe is no exception
Internal and external challenges mean that Europe's macroeconomic prospects remain moderate, with a slowdown in growth potential from around 1% before the pandemic to around 0.5% over the next five years.
According to our analysis, this slowdown is due to weakening demographics and slower productivity growth. The weak productivity outlook reflects persistent challenges, such as lagging in the global technology race, intense competition from China, and high energy prices compared to the period before the Ukraine war, all exacerbated by a less favorable global trade environment.
The shift in German fiscal policy towards greater defense and infrastructure spending is significant. However, we do not expect this to extend to the entire region, as it is unlikely that other major countries, such as France, Italy, and Spain, will increase unfunded spending due to debt sustainability constraints. Additional defense spending outside of Germany is likely to be largely offset by cuts in other areas. Overall, we expect a globally neutral fiscal policy in the euro zone over the next five years.
In nominal terms, it is unlikely that inflation will return to the 1% level recorded in the years prior to the pandemic, given deglobalizing pressures and somewhat higher inflation expectations. However, we expect inflation to stabilize below the European Central Bank's 2% target. Weak growth and inflation prospects will continue to anchor equilibrium interest rates, which will likely fall below the current nominal level of 2% suggested by our models over time.
Resilience across the region
As grim as it may seem, there is a silver lining: we expect the monetary union to remain stable on the horizon. The region has passed significant stress tests in recent years, including a pandemic and a war, demonstrating a strong political commitment to unity. This resilience has been backed by significant institutional advances, such as the ECB's assertion of its role as a reliable lender of last resort for sovereign states (through various asset purchase programs and tools to deal with sovereign tensions), as well as improved fiscal cooperation through cross-border fiscal transfers funded by the pandemic-related Next Generation EU program. Although Next Generation EU is conceived as a one-off measure, it offers a potential model for future recessions.
The current political landscape also seems less tumultuous. Although populist pressures are still alive, with far-right parties in power or gaining support, true Euroscepticism aimed at dismantling the EU and the monetary union has faded. For example, the perceived risks following the election of a far-right government in Italy quickly dissipated when the government adopted moderate economic policies. Support for the euro is currently at an all-time high, and political commitment to cohesion could be further strengthened in a more contentious global political environment.
However, risks remain. We are closely monitoring the situation in France due to the sharp increase in the debt/GDP ratio, difficulties in implementing spending cuts, and an already very high tax/GDP ratio. Even so, some fiscal adjustment is likely to eventually occur, which we would consider more of a specific risk premium for France than an existential risk for the region.
Investment implications: interest rates and exchange rates
The challenging growth prospects and the moderate inflation environment we expect suggest that European duration valuations should remain stable, and that German bonds will likely serve as a good diversifier in portfolios. In addition, the increased demand for safe European assets, driven by global diversification outside of the United States, could further support the duration.
The theme of steeper curves -mentioned in the Secular Outlook- also applies to Europe. Rates at the short and medium end of the curve should remain anchored by low equilibrium interest rates, while long-term yields are likely to remain high due to increased German issuance.
The stability of the monetary union should translate into relatively stable sovereign spreads with respect to German bonds (Bunds), which would allow investors to earn additional yield by purchasing a diversified basket of euro zone sovereign bonds. The line separating core countries from the periphery is also blurring, so investors should choose sovereign bonds based on relative fundamentals, rather than on traditional classification.
As for currencies, we do not believe that the US dollar will lose its role as the world's reserve currency. However, global diversification could provide a slight boost to the euro.
Investment implications: Corporate credit
In the realm of high-quality credit rated investment grade, the European market, with more than 4 trillion euros, offers abundant opportunities to invest in issuers that have been tested throughout multiple economic cycles and are very accustomed to operating in a low growth environment. Given the region's moderate GDP growth, many high-quality companies have adopted relatively conservative balance strategies, which provides them with ample financial flexibility to successfully face a variety of macroeconomic scenarios. Active management is key to finding these select opportunities.
The European market with investment grade rating also benefits from the inherent diversification provided by duration, which, around five years, is at the level where we see the most attractive risk-adjusted returns. Within the global credit universe, the lower sensitivity to interest rates of the European credit market has contributed to its lower volatility in recent years, positioning it advantageously in an environment of steeper yield curves.
Outside of the investment grade rating, the European high yield bond market has significantly improved in quality over the last 15 years, with over 65% of the market now rated BB. During this period, European high yield has offered returns comparable to the European equity market, but with notably lower volatility. As equity valuations continue to rise, credit has the potential to once again outperform in the secular horizon, but with only between a third and half of the volatility.
Lastly, European credit could naturally benefit from the growing number of investors looking to diversify their portfolios away from American credit, which is overwhelmingly concentrated in American companies.
