The factors driving Eurozone investment potential to the next level

The world is changing, and investors need to have a clear view of how, and what that means for Europe.

Western-led political hegemony is being challenged by a more inward-looking America, and the strengthening of collaboration between countries including China, Russia, India, and other large emerging economies.

It is clear there are significant implications for trade, official as well as private investment flows, and global security. Europe is a major economic bloc with substantial political influence on the world stage.

Yet, the narrative on the European outlook is less clear. For the US, the future is a technology-driven and more protectionist economy. For China, it is to reorient its economy away from exports and state-directed capital spending, towards a high-tech consumer services driven model with ongoing influence - economically and politically - beyond its borders.

In simple terms, others may feel compelled to align with one or the other, promoting bilateralism and power broking over multilateralism and collaboration.

Another direction

Europe can plough a different furrow. A lot of progress has been made in creating a unified European economy – the single market is a success, and so is the euro. However, achieving unified banking and capital markets has been painfully slow.

There is still no unified fiscal framework or meaningful collective mutual bond market framework. Regulation is too often seen to be holding back innovation. Several members of the European Union (EU) face difficult fiscal choices, against a backdrop of political fragmentation. Externally, the ongoing Ukraine conflict creates a fragile security situation in the east of the continent.

There is a recognition that Europe needs to address its challenges. In September 2024, former European Central Bank (ECB) boss and one-time Prime Minister of Italy, Mario Draghi, presented a report on European competitiveness that highlighted key vulnerabilities in a changing world. It broadly concluded that Europe is more vulnerable to trade disruptions than the US or China; is more exposed to energy market disruption, is lagging in the technology race and spends less on defence than other major powers.

His recommendations focussed on closing the technology gap with the US and China by boosting research and development spending and creating a more supportive financial system for funding start-ups, and liberalising capital markets. Draghi also urged Europe to continue to pursue decarbonisation as a way of improving energy security and adding to competitiveness.

Raising the stakes

Since Chancellor Friedrich Merz’s victory in the German federal elections in February, expectations have grown for a significant boost to Europe’s economy from his plans to increase spending on defence and infrastructure.

Such plans are broadly aligned with Draghi’s recommendations, incorporating themes such as digitalisation, modernisation of the electricity grid, and more spending on security. Other member countries have pledged to increase defence spending, under pressure from US threats to reduce its commitment to European security.

The timing of spending increases and how this will be funded across countries is unclear. However, there is clearly potential for increased output from several industries in the supply chains of defence, infrastructure, energy, and communications sectors. This has supported equity market performance in 2025.

In its recent European Economic Outlook, the consultancy firm KPMG argued that increased spending on defence could add around 0.3% to GDP by 2030 and increasing spending on research and development in the defence area could add even more, with positive spillover effects on various technologies that would also benefit civilian economic activities.¹  European aerospace and defence stocks have delivered strong total returns so far in 2025.

Europe continues to be a leader in sustainability, with the EU Green Deal supporting the energy transition and European investment activity governed by environmental and social factors to a much greater extent than in other regions. Along with government support, this should also contribute to long-term productivity growth. A case in point is the green bond market, which has proved how Europe’s financial markets can significantly contribute to the funding of the transition. 

Investment potential

The positives in the European outlook certainly draw on the recognition, epitomised by the Draghi report, of the need to boost competitiveness, accelerate the sustainability agenda and improve both economic and political security.

The EU adopted its “Competitiveness Compass” in early 2025 to set “a path for Europe to become the place where future technologies, services, and clean products are invented, manufactured, and put on the market”.²  With Europe’s existing strengths in areas such as renewable energy, digital and financial services, and technology, the potential opportunities for long-term equity investors are clear. The fact that European companies tend to pay out more to investors in dividends is also attractive, although this may change if focus shifts towards retaining earnings for funding investment.

However, in the short term there are challenges. Europe reached a trade agreement with the US in late July, but European exporters to the US will still face significantly increased tariffs. Europe is a more open economy than either the US or China, and as such, is at risk to anything that undercuts the competitiveness of European exports or puts up barriers to trade. For now, the hope is that greater clarity on trade will limit the downside to economic growth.

The OECD expects EU economic growth to be 1.0% this year and 1.2% in 2026.³  The global picture will remain difficult but lower interest rates in the Eurozone should help support domestic spending. Financial markets are currently not enthusiastic about pricing in further ECB rate cuts, but real short-term rates have fallen to zero and the broader credit outlook in Europe is supportive of investment. 

Budgetary challenges

Another concern is the fiscal outlook in some countries. France’s is especially concerning given recent political failures to make progress on fiscal consolidation. However, in aggregate the fiscal outlook stacks up well compared to that in the US, which should mean lower real bond yields and less market volatility. Spreads between Eurozone government bond yields are low and more stable than at any time since the European debt crisis more than a decade ago, thanks to better growth and fiscal consolidation in countries like Spain, Italy, and Portugal.

European equities should continue to deliver an attractive balance of growth and income returns in the year ahead. The backdrop of weak GDP growth has not prevented corporate earnings growing at a high single-digit pace. Meanwhile, European companies are adapting to the opportunities provided by artificial intelligence, as well as to the opportunities provided by the structural themes discussed above.

On the fixed income side, high yield bonds have been rewarding while European credit spreads reflect the health of corporate balance sheets. Growth needs to be stronger; further economic deepening and integration is necessary, and Europe’s ability to meet the challenges posed by geo-political change needs to be seen.

Ultimately, Europe can provide a different choice for investors, given the increased unpredictability of the US, and more political challenging destinations elsewhere. If European markets continue to thrive, the euro currency will perform well, and long-term investors should potentially be rewarded with healthy returns as growth becomes more sustainable in the region.