CIO Insights: Will Europe’s fiscal spark ignite real growth?

10 minute read

European equities have outpaced the US so far this year: euro-area stocks have gained about 25% year-to-date in USD terms, while the S&P 500 is flat. Part of this outperformance reflects a strengthening euro, which has boosted USD returns on European assets. Beyond currency movements, the rally has also been driven by a rotation away from US equities, and optimism over Europe’s landmark fiscal stimulus plans. 

With all the recent interest in Europe, a critical question for long-term investors to ask is: are we witnessing a lasting change in the region’s growth prospects? In this month’s CIO Insights, we’ll explore where Europe’s fiscal tailwinds meet its longer-term headwinds – and unpack where the opportunities and challenges lie on the continent.

Key takeaways

• Berlin and Brussels are opening the fiscal taps, a move that’s positive for growth. Between Germany’s infrastructure fund and the European Union’s (EU) investments in defence, public spending is set to rise noticeably in Europe. That extra stimulus should support growth in Germany in particular – with an estimated lift of up to 1.4% of GDP annually in the near term that could boost the economy’s growth potential in the longer term – with ripple effects across the continent.
• These stimulus measures aren’t a silver bullet – deep-seated structural headwinds will likely continue to weigh on Europe’s broad growth trajectory. As former European Central Bank (ECB) president Mario Draghi outlined in his report on European competitiveness, the EU still faces a number of hurdles – namely, high regulatory burdens and fragmentation, energy dependency, challenging demographics, and the lack of a fiscal union. While a surge in public spending is certainly a positive, they may not fully offset these constraints.
• There may be scope for cyclical gains in European equities, but a structural re-rating remains a high hurdle. As a whole, the region’s equities are still dominated by “old economy” sectors like financials and industrials, limiting their exposure to “new economy” growth drivers such as tech and AI. This sectoral composition, combined with the region’s structural challenges, also caps the potential for its broad equity markets. Any near-term upside is more likely to be a temporary valuation catch-up than a durable re-pricing.
• Europe’s overall growth trajectory may stay subdued, but there are pockets of opportunity in specific countries and sectors. We believe long-term investors should still include European equity exposures as part of a well-diversified portfolio, but other markets, like the US, are more likely to deliver better longer-term growth. That said, there are areas of opportunity. In the near-term, developments like ECB rate cuts are supportive for the financial sector. Over the medium and longer-run, the region’s fiscal stimulus and policy priorities may benefit sectors like infrastructure, defence and clean-tech, and economies such as Germany, Spain, and France.

Europe’s fiscal taps are finally turning on, but the benefits won’t flow evenly

In last month’s CIO Insights: The long view on “Liberation Day”, we shared how a shifting geopolitical order – intensified by Trump-era trade and industrial policies – is pushing countries to prioritise economic self-sufficiency.

With that backdrop in mind, Europe is stirring from years of fiscal restraint – with Berlin at the heart of this fiscal awakening. In March, the German government passed a landmark €1 trillion (US$1.1 trillion) spending package – including a €500 billion infrastructure fund and provisions for defence spending beyond 1% of GDP. Based on estimates from Bloomberg Economics, that could lift Germany’s annual public investment by 1.3–1.4% of GDP per year over the next decade. If you assume a fiscal multiplier of 0.8–1x (1), that should translate into a roughly equivalent lift in annual GDP growth.

That marks a big shift for a country long defined by its budgetary restraint. For much of the 2010s, Germany ran fiscal surpluses, and its public investment consistently below the euro-area average. As Chart 1 shows, Germany has maintained one of the lowest budget deficits among major developed economies over the past decade – but it also underscores the turning point now underway, with Berlin committing to materially higher levels of public spending.

Germany’s fiscal pivot could deliver meaningful macroeconomic benefits – but the impact won’t be immediate. Major infrastructure projects take time to get off the ground, and most of the stimulus is expected to materialise from 2026 onward.

Still, this would mark a pivotal shift after years of tepid growth – with GDP contracting in both 2023 and 2024, and expanding by less than 1% per year on average over the past decade. As the euro-area’s largest economy, this increased spending is expected to spill over across the continent by boosting demand for its neighbours’ goods and services.

At the EU level, the bloc has endorsed a separate €800 billion defence plan, allowing countries to temporarily deviate from fiscal rules. While this is promising, there are some hurdles. The bulk of the funding depends on national contributions – a challenge for economies with higher debt like France, Italy, and Spain. Even so, several governments are signaling intent. In France, President Macron has floated ambitions to raise defence spending as high as 3–5% of GDP; but without concrete plans to fund such an expansion, that goal remains aspirational for now.

In short, Europe’s fiscal landscape is changing – but not uniformly. Germany is able to ramp up investments due to its strong balance sheet. But many of its neighbors are limited by higher debt and fragmented politics. The pandemic-era NextGenerationEU (NGEU) programme offered a glimpse of what a true fiscal union could deliver, meaningfully benefiting countries like Spain and Italy, but those benefits expire in 2026 (2).

For gains like those to be more than a one-off, the region will need stronger bloc-level spending and coordination, and progress toward formalising mechanisms like NGEU and expanding them beyond exceptional circumstances.

Stimulus could light a fire under Europe’s economy – if it can tackle its structural drags

The path to a stronger European economy needs more than just stimulus – it requires structural transformation. As former ECB President Mario Draghi laid out in his report on EU competitiveness (3), Europe’s deeper growth challenge stems from long-standing structural weaknesses – many of which remain unresolved. We’ve identified four key areas:

• Regulatory burdens are a drag on innovation: Europe’s complex and fragmented regulatory environment continues to weigh on its competitiveness. More than half of European small and medium-sized enterprises (SMEs) cite administrative burden as their top challenge, and a 2023 BusinessEurope survey found that 83% of firms saw complex permit rules as a major hurdle to investing in the EU (4). The European Commission estimates that administrative burdens and a lack of harmonisation costs the bloc as much €350 billion annually – roughly 2% of GDP – and progress on reducing this drag has been slow.

• Energy dependency puts industries at a cost disadvantage: Europe’s heavy reliance on imported energy exposes it to higher and more volatile prices than its global peers, with industrial electricity costs 2–3x higher than in the US and China and natural gas prices up to 5x greater in some cases. Germany, one of the most energy-dependent economies in the bloc, imports about 65% of its energy – a vulnerability laid bare during the 2022 energy crisis. Here, Germany’s €500 billion infrastructure fund includes investments in its energy grid and could reduce external energy dependence over time.

• Demographics are unfavourable for growth: Europe’s working-age population is projected to decline by nearly 2 million annually through 2040 – a demographic headwind that will weigh on growth and fiscal sustainability. Morgan Stanley estimates that that could reduce euro-zone GDP by 4% by 2040 (5) – implying an annual drag of about 0.3 percentage points. Yet immigration, the fastest and most direct way to address this issue, remains politically unpopular: a February 2025 YouGov survey found that upwards of 70% of western Europeans believe immigration levels are too high (6). Without either demographic renewal or productivity gains, Europe’s growth risks stalling further.

• Lack of a fiscal union limits coordinated action: Europe may be flexing its fiscal muscles, but without a true fiscal union, its ability to act cohesively remains constrained. Common investment efforts are fragmented and heavily reliant on national budgets – limiting scale, impact, and the capacity for more-indebted countries to participate. This fragmentation undermines the EU’s collective economic firepower. As we shared earlier, the pandemic-era NGEU fund shows what’s possible by pooling resources and issuing joint debt – but that remains the exception rather than the rule.

These structural challenges highlight the challenges to Europe’s economic dynamism – which have weighed on the region for decades. As Chart 2 shows, euro-area growth has consistently lagged that of the US over the past 25 years – with average growth almost 1 percentage point lower – and suffered much bigger swings during crisis periods.

While European equities may see a cyclical upside, a lasting shift will be tougher to achieve

From a cyclical perspective, there is potential for euro-area equities to see some upside. As shown in Chart 3 below, with valuations at 14.9x forward earnings – roughly in line with the historical average of 14.3x – a short-term pickup is possible given recent momentum. A 5–10% uptick in valuations would keep the region within one standard deviation from this average.

Even so, Europe’s valuation gap with the US remains wide. The S&P 500 trades at 21.8x forward earnings, likely reflecting investor confidence in the US market’s longer-term growth potential, especially from tech and AI-led sectors. (For more on how we see AI shaping growth, see our 2025 Macro Outlook: “FAT” is the new normal.) Unless Europe can credibly close its structural growth gap, that discount may persist.

That’s especially clear when viewed through the lens of sector composition, illustrated in Chart 4. Unlike the US market, where innovation-driven “new economy” sectors like tech dominate equity indices, the euro-area is still tilted toward “old economy” cyclicals – financials (e.g., insurers like Allianz or banks like BNP Paribas), industrials (e.g., Siemens or Airbus), and traditional consumer discretionary (e.g., LVMH or Hermes). This sectoral skew limits Europe’s ability to benefit from technological advancements like those with AI, and it could partly explain the region’s persistent productivity gap with the US.

Given Europe’s uneven growth outlook, we see opportunities in certain sectors and countries

Europe's fiscal awakening marks a meaningful shift – especially in Germany, where large-scale spending is set to support growth and investment. But while this new wave of investment offers cyclical support, it’s unlikely to fully overcome the region’s deeper structural headwinds.

For long-term investors, we believe maintaining broad exposure to European equities as part of a well-diversified portfolio remains prudent. But we also see several pockets of opportunity emerging in the region:

• Ongoing ECB rate cuts are supportive of the banking sector: With inflationary pressures largely contained and US trade policy presenting a risk to growth, markets expect continued rate cuts from the ECB. That should continue to support rate-sensitive sectors like banks, particularly those with strong domestic lending businesses.
• Policy priorities are set to benefit infrastructure, clean energy, AI, and defence: These areas are central to the EU’s long-term competitiveness strategy, and are set to benefit from both targeted fiscal support and regulatory tailwinds. Clean-tech and grid infrastructure are key pillars of national climate plans, while the EU’s AI Act is driving investment in digital capabilities. Meanwhile, rising defence budgets will provide longer-term momentum for aerospace and defence firms with strong regional footprints.
• At the country level, Germany, Spain, and France stand out based on their markets’ sector composition: Germany is set to benefit from its large-scale public investments, particularly in infrastructure and defence-related sectors like industrials. Together with financials, which benefit from lower rates, that comprises about half of the country’s DAX Index. Meanwhile, Spain’s equity market is well-positioned due to its outsized exposure to renewables and financials. For its part, France's equity market has sizable exposure to industrials, which could benefit from ramped up defence spending.

In a year where markets are navigating both structural challenges and cyclical surprises, the case for global diversification has rarely been clearer. Our General Investing portfolios powered by StashAway are built with that in mind – to capture opportunities across geographies and asset classes, while managing risk through the economic cycle. Ultimately, what’s key is to  focus on what you can control: a long-term investing strategy that helps you capture opportunities as they emerge.

Glossary

Fiscal union

An arrangement where members share fiscal responsibilities, taxation powers, and potentially joint debt issuance. The EU has monetary union with a shared currency and central bank but lacks a full fiscal union, limiting coordinated economic policy across member states.

Fiscal multiplier

A measure of how much economic output is generated by each unit increase in government spending. When expressed in percentage terms, a multiplier of 1 means that increasing public spending by 1% of GDP raises total GDP by 1%.

Cyclical and structural factors (economics)

Structural factors are fundamental, long-term characteristics that shape an economy's growth potential, like demographics or productivity. Cyclical factors are shorter-term conditions that fluctuate with economic cycles, like interest rates or government spending.

References

1. Global Infrastructure Hub, The World Bank. (2020). Fiscal multiplier effect of infrastructure investment. Retrieved from: https://www.gihub.org/infrastructure-monitor/insights/fiscal-multiplier-effect-of-infrastructure-investment
2. Bańkowski, K., Benalal, N., Bouabdallah, O., De Stefani, R., Huber, C., Jacquinot, P., Nerlich, C., Rodríguez-Vives, M., Szörfi, B., Zorell, N., Zwick, C. (2024). Four years into the Next Generation EU programme: An updated preliminary evaluation of its economic impact. ECB Economic Bulletin, 8/2024. European Central Bank. Retrieved from: https://www.ecb.europa.eu/press/economic-bulletin/html/eb202408.en.html
3. Draghi, M. (2024). The future of European competitiveness. European Commission. Retrieved from: https://commission.europa.eu/topics/eu-competitiveness/draghi-report_en
4. BusinessEurope. (2024). Licence to transform: SWOT analysis of industrial permitting in Europe. Retrieved from: https://www.businesseurope.eu/publications/licence-to-transform-swot-analysis-of-industrial-permitting-in-europe-a-businesseurope-survey
5. Hogg, R. (2024). Europe’s population crisis could shave 4% off its GDP by 2040, Morgan Stanley warns, and the options to solve it aren’t good. Fortune. Retrieved from: https://finance.yahoo.com/news/europe-population-crisis-could-shave-050000629.html
6. Henley, J. (2025). Western Europeans say immigration is too high and poorly managed, survey finds. The Guardian. Retrieved from: https://www.theguardian.com/uk-news/2025/feb/26/western-europeans-say-immigration-is-too-high-and-poorly-managed-survey-finds