Capital Ideas^™ 
Investment insights from Capital Group

For years, sentiment toward Europe has been persistently gloomy. Concerns over weak growth, structural challenges and policy caution have sapped investor interest. Yet beneath the surface, conditions are slowly improving. Labor markets remain tight, domestic demand is firming and investment is increasingly being directed back into the region. These gradual but meaningful shifts suggest the outlook for Europe may be turning a corner, with important implications for equity investors seeking a globally diversified portfolio.

Global tensions are also contributing to the recovery in domestic demand. At the recent Munich Security Conference, colleagues heard how Europe’s evolving security strategy is increasingly translating into concrete fiscal and industrial investment at home.

Although consensus expectations for the eurozone remain restrained, growth forecasts are fairly muted and inflation risks are assumed to be fading. Monetary policy is also expected to remain on hold. My view is more constructive, as the eurozone economy has shown greater resilience than is commonly appreciated, despite substantial external headwinds. Here are two reasons why:

1. Domestic demand is stabilizing the eurozone growth outlook

Over the past several years, sentiment indicators led many to underestimate the region’s underlying resilience. Yet in 2025, actual activity outperformed those signals. One reason is the recovery in domestic demand has helped offset the drag from weaker exports.

The primary driver of this shift is Germany, Europe’s largest economy, where fiscal policy has turned meaningfully more supportive after years of restraint. This includes seismic fiscal reforms such as a new €500 billion infrastructure fund, as well as a substantial increase in defense spending. Together, these measures represent the largest fiscal stimulus in Germany since reunification in the early 1990s.

Although it took until later in 2025 for the government to begin spending the money, impacts are now visible via the sharp increase in domestic demand in manufacturing. By October 2025, new manufacturing orders in Germany began to reflect the impact of fiscal stimulus, with domestic capital goods orders rising strongly. This recovery should extend beyond defense spending and become more widespread across sectors in the months ahead as higher public investment filters through supply chains, boosts confidence and catalyzes a broader rebound in domestic capital expenditure.

For investors, this challenges the more downbeat view that the eurozone is overly dependent on external demand to generate growth. An expansion driven by improving domestic demand is likely to be more durable and less vulnerable to external shocks, improving the backdrop for European equities.

2. Wage growth remains stickier than policymakers expected

Resilient growth is one side of the story, while inflation dynamics are the other. Here, too, risks appear tilted to the upside relative to market pricing. Central to this view is the labor market. Despite slowing headline inflation, wage growth in the eurozone has remained elevated, reflecting structural labor supply constraints, an aging workforce and the lingering impact of recent price shocks on inflation expectations.

The European Central Bank (ECB) has repeatedly made upward revisions to its projection as wage growth has fallen more slowly than it anticipated.

This matters because wages are a key driver of services inflation, which tends to adjust more slowly than goods prices. If wage growth remains sticky, as I expect, it implies that underlying inflation pressures are likely to fade more slowly than consensus assumes. That, in turn, raises the risk that monetary policy remains more restrictive, or tightens even further, than markets currently expect.

Indeed, while investors are pricing a small chance of further ECB rate cuts, my above-consensus outlook allows for the possibility of one to two hikes later in 2026. Although 25 to 50 basis points of hikes would still leave ECB interest rates within the neutral range (meaning they are neither expansionary nor contractionary for economic activity), the direction of travel contrasts with expectations for further easing elsewhere, including in the U.S. 

Why this matters for equity investors

The near-term economic outlook in the eurozone looks brighter than most expect, given resilient growth and looser fiscal policy. Accordingly, I believe inflation risks appear more benign and ECB policy may tilt more hawkish.

For equity markets, this environment should be supportive. The strong performance in European equities last year, measured in local currency, was driven by rising valuations. But a recovery driven by domestic investment and consumption suggests a more supportive backdrop for earnings growth, particularly for those companies tied to infrastructure, industrials, financials and services. For U.S.-based investors, the continued strengthening of the euro in 2026 should also support returns.

From a portfolio perspective, this reinforces the case for international diversification. Investors concentrated in U.S. equities may be underexposed to regions where macro conditions, policy dynamics and earnings trajectories are evolving differently than consensus expects.