CONTRIBUTORS
Gautam Soundararajan
Research Analyst
The eurozone stands at the center of a policy tug-of-war with offsetting implications for the region. Over the near term, escalating trade tensions and tariff uncertainties with the US have pushed growth expectations lower. But longer-term, increasingly accommodative monetary and fiscal policies are building momentum for a sustained economic expansion, with the European Central Bank's (ECB’s) aggressive easing cycle and unprecedented defense spending commitments creating powerful growth tailwinds. However, even with the significant threat of tariffs and sharp appreciation in the euro (EUR), the region has shown surprising economic resilience. One case in point is the eurozone manufacturing Purchasing Managers' Index (PMI), which has risen to the highest level in three years. This unexpected development suggests, at least for now, that growth-positive forces, including monetary easing and fiscal stimulus, have successfully overcome negative tariff headwinds.
Trade and tariffs: Past peak uncertainty
Tariffs represent the largest near-term headwind to the eurozone this year as the region remains deeply connected to the US market. Eurozone growth forecasts for 2025 were revised to a trough of 0.8% after Trump’s April Liberation Day, down from 1.4% in the third quarter of 2024 (see Exhibit 1). While discussions are still ongoing, trade deals are being formed, suggesting peak uncertainty is behind us.
Current deal terms include an effective tariff rate near 15%, including a 15% baseline tariff on most EU goods entering the US and higher tariffs on some sector-specific goods, like steel and aluminum. Tariffs on other notable exports, like autos, pharmaceuticals, and semiconductors, are still under review. The EU also committed to opening its market to US goods at a 0% tariff rate. In addition, the EU agreed to purchase $750 billion in energy products over the next three years, make $600 billion in capital investments into the US, and procure “significant amounts” of military equipment. It is unclear how feasible these purchase commitments will be as there are only limited details regarding timing and enforceability.
While European Commission President Ursula von der Leyen has stated that energy purchases are feasible, the math would require a significant change in the region’s energy dynamics. For reference, the EU imported approximately EUR 465 billion in energy from non-EU countries in 2024. The US, which is already the second-largest energy supplier to the EU, exported approximately EUR 77 billion in energy to the region that same year (see Exhibit 2). In order to meet the new purchase commitments from the US, the EU would need to significantly increase its energy consumption or reduce trade with other partners, both of which may be difficult.
The terms of the trade deal between the US and EU mimic those between the US and other countries, like Japan and the UK. Thus, while the details around implementation are still unclear, we appear to be past peak uncertainty. Tariff rates are higher than they were before President Trump’s second term, but they are lower than the rates initially threatened and in line with analyst estimates. The deal also avoids an escalation that could have encompassed non-tariff barriers and value-added taxes (VAT). Importantly, the deal largely maintains the status quo of trade relations between the US and EU. However, we are seeing signs of deepening economic and trade relations with other countries. China, for example, is taking over idle European factories, providing access to rare earth minerals, and sharing advanced technology with the EU. The market has reacted positively to these developments, with full-year 2025 growth forecasts rising to 1.1%, as of August 2025.
Financial markets have swiftly recovered from the buildup to and selloff around Liberation Day. Equity indices are trading near all-time highs, stocks of many major auto makers have partially recovered, investment grade and high yield credit spreads are trading at or near post-Global Financial Crisis tights, German 10-year bond yields remain rangebound between 2% and 3%, most European government bond spreads continue to grind tighter, and the euro is holding onto its 5% rally this year. Despite the risks to the real economy from tariffs, markets seem to be looking through the noise.
Policy support: Large stimulus should overcome cyclical pressures
The combination of monetary and fiscal accommodation represents the most significant policy stimulus the eurozone has deployed since the sovereign debt crisis, creating a foundation for sustained economic expansion that extends well beyond current cyclical pressures. The ECB initiated one of the most aggressive rate-cutting cycles across advanced economies, lowering the policy rate by 200 basis points (bps) to 2% within the last year. While the ECB is likely near the end of its cutting cycle, with the market pricing in only one more 25bps cut, it takes time for policy decisions to permeate through to the real economy. However, we are beginning to see signs of the economy picking up.
Examining the banking sector, household borrowing shows tentative signs of revival as interest rates on new loans have declined from peak levels in 2024 (see Exhibit 3). Loans issued to households are picking up and are now near their 20-year average growth rate. Similarly, interest rates on loans to non-financial corporates have fallen 1.5% and 0.5%, respectively on new and outstanding loans, and loan issuance has picked up (see Exhibit 4). The private sector is not overly levered. With the credit-to-gross domestic product (GDP) gap well below its historical average, we see more room for stimulative activity over time (see Exhibit 5). Finally, lending margins on loans for home purchases have risen sharply and are now back in line with historical averages. Importantly, all this was done without loosening credit standards.
This positive momentum has spilled over into the construction sector as well. As of the first quarter of 2025, real construction investment now has had two consecutive quarters of growth. And more recently, we are seeing strength broaden from non-residential construction, which was supported by public investment, to residential construction. However, the inter-country story presents a more mixed picture. Investment activity in Italy and Spain has been strong due to use of the EU’s Recovery and Resilience Facility. Now that the election is over in Germany and political uncertainty reduced, we are likely to see increased infrastructure spending there as well. France, on the other hand, continues to be plagued by fiscal and political headwinds that weigh on activity. In aggregate, a pickup in construction activity is a bullish sign for the broader economy as it constitutes a meaningful share of EU GDP and employment.
Simultaneously, the fiscal thrust initiated by Germany, the Next Generation EU program, and the ReArm Europe plan are set to boost spending on defense, infrastructure, digital, and climate-related projects. European countries have committed to increasing defense spending to 3.5% of GDP in 2035 from 1.8% of GDP in 2024. In the near term, much of this increased funding will be used on imports. Over the long-term, Europe has the opportunity to grow its domestic defense and infrastructure capabilities. Additional areas for optimism in the EU could arise from further development of the pharmaceuticals and green energy industries, greater integration and harmonization of the capital markets, joint debt issuance, and reduced regulation. Recent reports to the European Commission from former ECB President Mario Draghi and former Prime Minister of Italy Enrico Letta have called for European leaders to make the region competitive again, but we will have to wait to see if more concrete action is taken in the near term.
Lastly, a conclusion to the Russia-Ukraine war could provide a modest boost to growth. First, ending hostilities could boost consumer and business confidence in the region and stimulate activity. Second, energy price volatility may decline. Europe has reduced its reliance on Russian gas since the onset of the war and is unlikely to resume large-scale imports if the war were to conclude. But a normalization of energy supply dynamics could limit sharp moves in gas prices. Third, defense spending is likely to remain high even with a conclusion to the war. Countries have recognized the extent of their vulnerabilities and are unlikely to back down from their new spending targets. Fourth, reconstruction of Ukraine could create opportunities for European firms, especially in the housing and transport sectors. In aggregate, the impact on growth is estimated to be small but positive, nonetheless.
Conclusion: Structural progress over cyclical trade disputes
The fundamental tension between supportive domestic policies and challenging trade dynamics will likely resolve in favor of policy accommodation given the structural nature of monetary and fiscal support versus the cyclical character of trade disputes. The ECB's commitment to growth support and the unprecedented nature of European spending represents durable policy shifts that should generate cumulative economic benefits extending well beyond current trade difficulties.
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