Europe – facing challenges or another eventual crisis?

The Santa rally is in full swing with just two weeks left before Christmas.

The S&P 500 has now registered 57 all-time highs this year. That is the fifth most in almost 100 years of data. Last week’s rally was driven by a surge in the largest technology stocks in the index. A basket of mega cap tech stocks has now posted gains of 65% this year alone.

A slight uptick in the unemployment rate in Friday’s U.S. nonfarm payrolls report to 4.2% meanwhile gave bond markets a boost. Yields have now fallen close to 30 basis points (bps) from their post-election peak. The dollar has also lost some ground but remains strong.

Europe rallied to its best weekly performance since September despite another bout of political uncertainty in France. The euro was stronger on the week, and the spread between French and German borrowing costs actually tightened. That marked a drastic turnaround from the moves earlier in the week when budget concerns first made headlines. European economy is on shaky foundations though.

In today’s note, we dig into what is behind the recent woes in Europe, what might be done by governments in 2025, and how investors should be viewing the investing landscape in the region.

Is Europe headed for another crisis?

Headlines last week revolved around the passing of a no-confidence bill in French parliament for the first time since 1962. That motion forced Prime Minister Michel Barnier and his government to resign, leaving President Macron to appoint a replacement in the coming days. The new premier will be tasked with passing a budget for 2025 before the parliamentary consultation period ends on December 21^st – an uphill battle that is looking increasingly improbable without substantial compromise with the far-right National Rally and left coalition.

Political instability isn’t something that France (and Europe at large) has been a stranger to this year. That started with a snap election from President Macron back in June, that left the lower house of the French government in a very divided state among three major blocs. That made it increasingly difficult for Barnier’s government to pass legislation aimed at reducing France’s budget deficit by €60bn next year in an effort to move back towards European Union (EU) imposed targets. That came to a head when the outgoing PM resorted to a constitutional mechanism to push through an unpopular social security bill without a parliamentary vote last week.

That is just the latest in a string of bad news for Europe in recent months. Germany faced its own spell of political turmoil in November when Chancellor Olaf Scholz ousted his finance minister and called for a snap election in Germany. The reason? Disagreements over the deployment of public finances. That comes at a time where Germany’s manufacturing sector – which has traditionally been Europe’s growth engine for decades – has stagnated. All this begs the question as to whether we are on the verge of another Eurozone debt crisis?

We think not. The concern back then was over excessive leverage in peripheral (i.e. non-core) economies. Countries like Greece, Ireland, Spain, and Italy had accumulated large amounts of debt due to higher government spending following the global financial crisis. Eventually, a loss of confidence among investors led to a sharp rise in borrowing costs that ultimately required a response from policymakers to provide bailout packages.

Much of the recovery from the crisis was attributed to Germany and France’s economic strength and political unity. The two economies alone account for 40% of the European Union’s gross domestic product today. Germany’s growth has primarily been export-driven, while France has borrowed to invest in its economy and Germany and peripheral economies deleveraged their public finances.

Growth challenges are creating political angst, with impacts on confidence amongst businesses and consumers. However, the market risk from recent events looks fairly isolated to France thus far, with little-to-no spillover to the periphery or broader markets. But the odds are still stacked against Europe as a whole.

As we highlighted in our 2025 Outlook, Europe has been lagging on the productivity front. Labor productivity in Europe is around four percentage points behind where forecasters estimated it would be before the pandemic (while the U.S. has slightly exceeded expectations). And that is just the latest part of a larger divergence since the global financial crisis.

Why has there been such a divergence? Europe’s reliance on energy imports has meant that natural gas prices are almost 30x higher than U.S. equivalents. A lack of investment in technology has limited Europe’s competitiveness in the artificial intelligence race of recent years. And outside of Japan, no region has a higher proportion of their population over the age of 65 at around 20%. As former ECB President Mario Draghi highlighted, each of these are structural problems that take time and investment to address.

Weaker productivity and ageing populations reduce the output of an economy and, in turn, the tax revenues for governments. That makes for more difficult decisions on government spending and taxation in 2025, whether by adherence to EU-wide rules or domestic rules (like Germany). We will be watching France in particular, with a “rolling budget” looking increasingly likely for next year.

Growth is already weak in much of the region (with the exception of some economies like Spain), and potential tariffs on exports to the U.S. add further downside pressure. But tight public finances mean that any response would need to come from the monetary side rather than fiscal. In other words, with little spending capacity for governments, we think that the European Central Bank will need to cut below 2% in 2025 to support the economy. This week’s meeting will provide the latest look at that.

To us, that may provide an opportunity to extend duration in European fixed income. And with potential further divergence with Fed policy, the euro will probably continue to be an underperformer in the currency space relative to higher carry currencies like the dollar and pound.

Despite the sluggishness in Europe, the muted market reaction suggests that a lot of the pessimism could already be priced in. For that reason, we do still think that there are pockets of opportunity. Several companies with exposure to sectors like industrials are well-positioned to benefit from structural themes. Private markets can also be compelling way to gain exposure to the continued build-out of infrastructure in the region.

Please reach out to your J.P. Morgan team for any further questions.