Geopolitical tensions remain a significant concern, with the persistent war in Ukraine and the Middle East continuing to be a potential hotspot for conflicts despite some recent de-escalation. Additionally, recent signals from the new US administration hint at potential new areas of geopolitical tensions (Panama Canal, Greenland). Any escalations could amplify uncertainty, trigger commodity price spikes, further increase shipping costs, and create bottlenecks in global trade. These developments could reignite inflation and adversely affect global economic activity, with Europe being particularly vulnerable to global shocks due to its high degree of openness.
In the short term, economic activity may also be lower due to a prolonged downturn in manufacturing, delayed consumer recovery, and subdued investment. Risks for the manufacturing outlook are skewed to the downside as the structural loss of competitiveness by European producers, not least due to higher energy prices and intensifying competition from China, may be more pronounced than currently anticipated. Meanwhile, we expect consumers to gradually reduce their currently very high saving rates, and investment to rebound on the back of lower interest rates and NextGenEU spending. However, global uncertainty may negatively affect business and consumer sentiment, delaying the consumer and investment recovery.
Adverse weather conditions or local political unrest could also reduce the supply of or increase demand for energy and food commodities, leading to higher inflation and diminished economic activity. Moreover, with inflation no longer fueling revenue growth or aiding in the reduction of debt-to-GDP ratios, the risk of renewed stress remains elevated in the sovereign bond markets of emerging economies as well as in Southern Europe.
Despite these significant downside risks, several factors could positively influence growth. Inflation may prove lower than expected if services inflation declines more rapidly, core goods inflation remains subdued at close to 0%, or positive supply shocks alleviate food inflation. Lower inflation would boost household disposable incomes and consumption. Concurrently, it would allow central banks to cut interest rates more aggressively to levels below current projections, providing an additional stimulus to investment and consumption.
European consumers may also reduce their saving rates more quickly than anticipated from the presently high levels, or even spend a portion of their substantial excess savings accumulated during the pandemic, resulting in stronger GDP growth. Over the medium term, it is unlikely that the saving rate will stay significantly above pre-pandemic levels, especially as incentives to save diminish with declining ECB interest rates.
Productivity growth, which has been notably weak over the past decade, represents another upside risk to the outlook. Tight labor markets should encourage firms to invest in productivity-enhancing and labor-saving technologies, including automation, robotization, and the potential of generative AI. In a recent series of EY articles, we highlighted AI’s substantial potential to transform the labor market, boost investment, total factor productivity, and GDP growth, albeit with uneven effects across sectors. However, AI may also contribute to higher inflation and interest rates.
Lastly, strong immigration flows could alleviate demographic pressures and support potential growth. Our baseline scenario predicts that labor supply in Europe will plateau after 2025 and decline post-2027, driven by demographic trends, with several countries, particularly in CEE, facing earlier and more severe reductions. However, tight labor markets in Europe and ongoing global population growth present an upside risk that immigration could at least partially offset these gaps. This scenario appears more plausible in CEE, which had not experienced significant immigration prior to the large-scale influx from Ukraine, rendering immigration projections typically conservative.