Can Europe meet the moment?

2025 ends on a good note

The euro area delivered an encouraging surprise in Q4 2025, with
0.3 percent quarterly GDP growth outpacing consensus expectations and
driving full-year growth to a solid 1.4 percent despite persistent trade
tensions and heightened global uncertainty. Germany, Italy and Spain
accelerated, suggesting underlying resilience across the bloc’s largest
economies.

Lower rates, stronger banks, easier financial conditions

The European Central Bank’s (ECB) substantial 200 basis points (bps) of
rate cuts since June 2024 have been instrumental in supporting growth.
With inflation hovering around the ECB’s two-percent target, we believe
the deposit rate is likely to remain steady at two percent throughout
2026, though a persistently strong euro could pose a downside risk to
price pressures.

Lower interest rates have spurred a recovery in bank lending, and banks
are in a markedly stronger position to meet loan demand following a decade
of heightened regulation and private sector deleveraging after the 2012
sovereign debt crisis. The continent’s top 18 banks are better
capitalised, with a Tier 1 capital ratio averaging 13.7 percent, according
to RBC Capital Markets.

Economic resilience was further supported by a narrowing of most sovereign
bond spreads – the yield premium over German Bunds – which eased financial
conditions. The widest major eurozone sovereign bond spread has compressed
from over 150 bps two years ago to closer to 60 bps today, despite heavy
sovereign issuance and the ECB’s balance sheet reductions. This spread
compression reflects fiscal improvements in previously vulnerable
economies, as well as increased investor confidence in the ECB’s role as a
backstop and its institutional framework, which seems to be less
susceptible to political interference than its U.S. counterpart.

Looking ahead, we think the momentum could well be maintained. The
European Commission’s economic sentiment indicator reached its highest
level in three years in Jan. 2026. While most euro area economies will
undertake fiscal consolidation in 2026, Germany’s €500 billion
infrastructure program announced in April 2025 is likely to support
regional sentiment. The German government is projecting the federal budget
deficit to widen from 1.1 percent of GDP in 2024 to a still enviably low
3.7 percent from 2026 onwards.

Overall, we expect a modest cyclical upturn in 2026, with RBC Global Asset
Management recently increasing its 2026 GDP growth forecast for the
eurozone to 1.8 percent, above the consensus level of 1.2 percent.

Europe in the new world order

U.S. President Donald Trump’s recent threats to annex Greenland, a Danish
territory, and to impose punitive tariffs on European countries opposing
the plan rattled Europe. As RBC Global Asset Management Inc. Chief
Economist Eric Lascelles wrote, the Greenland saga “emphasizes that, in
addition to being an unreliable trade partner, the U.S. is now an
unreliable military partner … There is even the previously unfathomable
risk that, as with Venezuela and Greenland, the U.S. could be the next
adversary.”

Although the threats were withdrawn, they inflicted lasting damage on
EU-U.S. relations. In response, European Commission President Ursula
von der Leyen underscored the need for European strategic autonomy by
deepening the single market, expanding the network of free trade
agreements (FTAs), and bolstering security capabilities.

Strengthening the single market

Europe’s predicament may reinvigorate momentum behind the measures
proposed by former ECB President Mario Draghi in 2024 urging EU leaders to
address the bloc’s persistent productivity shortfall by deepening the
single market, boosting innovation and diversifying supply chains. While
implementation has been slow, there has been some progress, with
15 percent of Draghi’s 383 reform proposals now fully implemented, up from
11 percent last September.

Against this backdrop, the EU has stepped up work on several targeted
initiatives to strengthen the single market in practice. Issues to be
discussed at a Feb. 12 summit include the proposed Industrial Accelerator
Act, which would streamline regulations and boost investment across key
industrial sectors, and modifying the regional emissions trading system to
reduce the cost of doing business.

On the financial side, German Chancellor Friedrich Merz recently
reiterated the need for progress on a capital markets union. In Oct.
2025, Germany indicated its willingness to cede certain supervisory powers
to the European Securities and Markets Authority – a significant departure
from its longstanding opposition to EU-level regulatory centralisation.

A broad network of FTAs

Von der Leyen sees expanded FTAs as critical to strengthening Europe’s
economic power. The EU recently concluded two landmark agreements after
decades of negotiations, securing access to critical products, resources
and markets.

The pact with the Mercosur nations (Brazil, Argentina, Uruguay and
Paraguay) enhances access to critical minerals, diversifying Europe’s
supply base. The FTA with India reduces tariffs on European cars from
around 110 percent to just 10 percent for up to 250,000 vehicles annually.
This could turn India, which imported just 10,000 cars from the EU in
2024, into a major auto export market.

Lascelles notes that both agreements represent meaningful steps towards
trade diversification, though bilateral trade with Mercosur and India
combined remains just one-quarter of EU-U.S. trade.

Security

Lascelles believes the Greenland episode has accelerated the military
spending theme, with a pronounced pivot from within Europe that we
anticipate will positively impact the EU economy. As Lascelles does not
expect higher defence expenditures to be offset by cuts elsewhere, he
anticipates a significant fiscal expansion ahead that could exceed
consensus estimates. We note that eurozone public debt has returned to
near pre-pandemic levels of some 85 percent of GDP.

Investing in Europe

Last year’s optimism following the announcement of the German stimulus has
faded – perhaps overly so, in our view. We believe the impact of the German
investment program is now underestimated, as investors focus on
structural challenges.

The MSCI Eurozone Index is trading at 16.3x 2026 consensus earnings
estimates, a premium to its median valuation since 2003, though we view
this as justified given the region’s improved economic momentum and
earnings growth prospects.

Political risk remains in France but is likely contained until the 2027
presidential election. A strong euro poses a headwind to European
exporters’ earnings, but this is likely to be offset by more buoyant
economic activity.

Europe merits a Market Weight allocation within global portfolios, in our
view. Beyond geographic diversification, we believe the continent presents
compelling investment opportunities. We expect companies exposed to the
German spending plan – particularly select Industrials, defence and
Materials – to do well. Banks are also attractive, in our view, supported by
a steepening yield curve and improving loan demand, while trading at a
valuation discount to their U.S. peers.