A mixed bag – the regularly quoted characterisation of the Eurozone has barely been more applicable than in recent years. In the last four years, the area’s overall GDP rose by an aggregated 4.7%, lagging behind the 12.1% registered in the US. Moreover, growth trajectories are diverging within the Eurozone. Southern countries such as Spain, Italy, Greece and Portugal outperformed. The Eurozone’s two largest economies, Germany and France, lagged. Germany even shrank marginally in the last two years. Could this change?
Germany heads to a crucial election on 23 February. The list of economic problems in the world’s fourth-largest economy includes German-specific issues such as high energy costs, too much red tape, and accumulating problems for its largest industry, automotives. On top of this, Germany faces external risks, given the large trade deficit the US has with Germany. Trump hasn’t (yet) targeted the European Union directly with broad-based tariffs. However, given how he has regularly criticised the EU and, in particular, Germany for running trade surpluses with the US, the risk of higher tariffs looks high.
US-Eurozone growth gap widening with ongoing German stagnation
In the second part of 2024, as it became increasingly clear that Trump was likely to win the US election, the gap in 2025 GDP growth forecasts between the US and the Eurozone widened significantly. Consensus is now 2.2% for the US, 1.0% for the Eurozone, and a meagre 0.4% for Germany. Current economic activity data also highlight Germany’s and the wider Eurozone’s economic weakness. Purchasing Managers’ Indices still lag other regions despite a slight recovery in January. In addition, the expectation component of Germany’s Ifo business climate survey of about 9,000 companies that declined in the last three months to the lowest level in a year is indicating ongoing weakness.
Consumer confidence has stabilised, albeit at moderate levels. Nevertheless, households in Germany and across the Eurozone are saving more and spending less, which is impacting retail sales growth. The main reason for this is the uncertainty around economic policy, which has risen even more since the US election.
Spotlight on the German election – a new government very likely
Current polls for the “Bundestagswahl” point to a CDU/CSU (former Chancellor Merkel’s party) win with roughly 30% of votes. This would mean that their leader, Friedrich Merz, will likely become the next Chancellor, replacing Olaf Scholz. The pending question is the composition of the next coalition. A two-party coalition might be possible with the Social Democrats (current Chancellor Scholz’s SPD) or even with the Greens, currently ranked fourth in the polls. However, it also depends on whether the three smaller parties manage to surpass the 5% threshold to enter parliament. What’s ruled out by the established parties, though, is a coalition with the far-right AfD (ranked second in the polls). According to surveys, a quarter of German voters are still not sure which party to vote for.
The manifesto of Merz’s party focuses on several growth-oriented measures ranging from reducing the tax burden to more incentives to take up work. While we believe that a two-party coalition could support German growth, a three-party coalition would likely make it more complicated to do so. However, while the CDU/CSU stresses budgetary prudence, they look ready to push for more public debt. That said, fiscal support would be limited as the CDU/CSU wants to keep the German debt break, possibly by making it somewhat more flexible. Germany recorded only a 2.6% budget deficit in 2024 based on a first official estimate, less than half of that of France or the US. Compared to G7 and other countries, Germany also has a much lower debt-to-GDP ratio, meaning it theoretically has debt firepower to support spending and investment.
Further European Central Bank cuts and our positioning
With Eurozone inflation edging closer to its 2% target, we expect the European Central Bank (ECB) will continue cutting its key (deposit) rate in 2025 to 2% from 2.75% currently. Given the divergence in rates and growth trajectories, we expect the euro to remain weak vs the US dollar in the short term before stabilising. A weak euro should remain a tailwind for Germany’s export industry. As inflation falls, household savings could normalise, and real wage growth could improve. All in all, this points to better prospects for Germany and the Eurozone in the second half of 2025.
We are neutral on Eurozone equities and corporate bonds due to (geo)political risks and ongoing weak growth prospects. Instead, anticipating further ECB cuts, we shifted to safer, mainly short-dated government bonds and extended an ‘insurance’ instrument. To become structurally more positive on European assets, we would need to see policy changes like those outlined above and a decline in uncertainty – across geopolitics, local politics, international trade and the Russia-Ukraine conflict. While this remains an open question, partial steps in this direction could not only improve confidence but also result in lower energy prices, supporting the Eurozone and Germany in particular.
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