Europe Outlook: Zeitenwende!

The euro-zone will get a boost from Germany’s decision to ditch its fiscal rules and ramp up defence spending, as well as the relaxation of the EU’s budget rules. But governments other than Germany won’t loosen policy very much, and the region’s industrial sector will continue to suffer from poor competitiveness and weak global demand, with higher US tariffs acting as an additional headwind. So we think economic growth will accelerate, but not dramatically, over the coming year or two. In the near term we expect the ECB to cut its policy rate two more times as growth remains sluggish and core inflation declines. But next year policymakers will raise interest rates again in the face of a Germany-led recovery. Meanwhile, public finances remain fragile in France and Italy so we expect spreads in those countries to rise even as they fall further in Spain and Portugal.

Outside the euro-zone, we think monetary loosening cycles are over in Switzerland and Sweden. Norges Bank is likely to cut rates a couple of times but leave interest rates high by European standards.