Neutral on Europe, but bright spots remain

Malaysian Reserve

a day ago

The need for precautionary savings has increased amid lingering uncertainties
by IFAST RESEARCH TEAM
THE European Union (EU) has recognised the urgency to pursue military independence amid US President Donald Trump's withdrawal of security support from NATO, prompting a surge in defence budgets across the region. At EU level, president Ursula von der Leyen announced the 'ReArm Europe' plan, a fiscal stimulus of €800 billion (RM3.84 trillion) over four years, aimed at raising defence spending from 1.9% to 3% of GDP.
Meanwhile, Germany, traditionally reluctant to take on debt, has exempted defence spending from its fiscal cap and introduced a €500 billion infrastructure and defence fund, marking a significant policy shift. Together, these measures have bolstered sentiment across Europe, with the eurozone manufacturing Purchasing Managers' Index (PMI) rising to a 27-month high in April, indicating early signs of a bottoming-out in the industrial sector, further supported by improved industrial production.
Inflation has eased considerably to 2.2% in April from its previous highs of 10.6%, largely driven by a decline in energy prices. Service inflation has also moderated, from 5.6% to 3.9%, reflecting broader disinflationary trends. With inflationary pressures moderating, the European Central Bank (ECB) is now on track to further cut rates, following seven consecutive cuts, thereby lowering borrowing costs and supporting economic recovery.
Economic Data Points to Tentative Recovery
Despite the easing of inflation and the improvement in consumer purchasing power, consumption is yet to show a convincing recovery. Retail sales growth remained tepid in the previous months, although the latest March data came in somewhat stronger than expected.
Nevertheless, the broader trend still points to cautious household behaviour, with the savings rate remaining well above the long-term average. The need for precautionary savings has increased amid lingering uncertainties — from the Russia-Ukraine war and ongoing trade tensions to the re-election of Trump, which has reignited geopolitical concerns.
European natural gas prices have declined significantly from their 2022 peaks, alleviating one of the biggest post-war cost burdens for manufacturers. Nonetheless, prices remain above the historical averages, continuing to weigh on the region's corporate competitiveness. Manufacturing PMI has stayed in the contraction zone, whether the recent rebound marks a true turnaround or only a tentative recovery, will take further time to prove.
Threat of Tariff Impact on Exports
Adding to the uncertainty, escalating trade tensions with the US pose an additional risk to Europe's growth outlook. The US is the largest exporting destination for EU goods, accounting for over 20% of the bloc's exports. Following recent US tariff measures, the average tariff rate imposed on EU products could rise sharply from 1.47% to 15.2%, according to Bruegel. As a significant share of the EU's GDP is tied to exports, the materialisation of these tariffs jeopardises Europe's growth outlook.
However, the EU retains several cards to play in retaliation against these measures. As one of the US' largest trading partners, the EU's countermeasures could contain or even reverse some of the US' tariffs. The EU has already responded with targeted tariffs impacting up to US$13.5 billion (RM57.34 billion) worth of US exports, carefully focusing on goods from Republican-leaning states — such as soybeans — in an effort to pressure Trump's core political base.
If the situation deteriorates further, the EU has even stronger options, including tightening regulations on US tech firms operating within the bloc. Given that Europe represents one of the largest markets globally for both the products and services of American technology giants, any measures targeting these companies could strike at a core pillar of the US economy. Nonetheless, the EU remains reluctant to escalate the conflict aggressively, maintaining a preference for a negotiated solution despite the confrontational stance from Washington.
More importantly, as the US pulls back from global trade, other countries are likely to diversify their trading relationships and form new alliances. In this context, Europe could play a more prominent role in global commerce. This shift may also support the euro, particularly if it gains traction as a currency for invoicing international trade. A more widely used euro would, in turn, help reduce borrowing costs across the euro-area.
Trump's challenges to independent institutions — such as the Federal Reserve (Fed) and universities — as well as to the rule of law, have made Europe's institutional framework appear more stable by comparison. The EU's commitment to the rule of law, with its system of checks and balances, remains a foundational strength. Moreover, Europe continues to show openness to trade and foreign investment.
Widening Innovation Gap Between Europe, US
However, much still hinges on long-overdue reforms, including the development of larger and deeper capital markets. Europe is falling behind in the artificial intelligence (AI) race, with the largest advancements in chips, language models and AI applications dominated by US companies. A key factor is Europe's insufficient research and development (R&D) investment. The gap in R&D spending as a percentage of GDP is widening between the EU and the US, driven by Europe's less developed venture capital market. In 2023, US venture capital funding was three times larger than Europe's, attracting more AI start-ups to the US for financing.
With limited access to venture capital and government funding, European start-ups are often forced to rely on bank loans or seek capital abroad, stifling innovation. Unless substantial progress is made in capital market integration, Europe risks falling further behind in productivity growth compared to other major economies. This challenge is compounded by an aging population, which not only reduces the labour force but also exerts additional pressure on productivity.
Key Takeaways
While macro indicators are yet to show a convincing recovery, select sectors offer pockets of resilience and opportunity. Home to numerous multinational pharmaceutical and medical device companies, Europe's healthcare sector stands to benefit from the surging global demand for weight-loss and diabetes treatments, particularly those developed by Novo Nordisk.
Key catalysts include projected record-high sales of weight-loss drugs and advancements targeting higher weight-loss efficacy, both of which could drive strong stock performance. Another sector that could deliver stronger performance is technology. Though tech is a relatively small sector in Europe, some key companies play a critical role in their respective field.
The views expressed are of the research team and do not necessarily reflect the stand of the newspaper's owners and editorial board.
This article first appeared in The Malaysian Reserve weekly print edition