Eurozone - The storm before the calm

Despite the US tariff storm, sentiment around the eurozone economy has shown a remarkable improvement over the past half year. After the energy crisis stagnation, the economy exhibited resilience already last year, and grew by 0.6% q/q in Q1 of 2025. While heavily distorted by a frontloading of goods in anticipation of US tariffs, for instance of Irish pharmaceutical products, domestic demand was also strong. Germany meanwhile followed through on the coalition agreement promise to ramp up defence and infrastructure spending, also raising hopes of higher future demand. And countries like Spain and Portugal continued their growth outperformance. In other areas, the pendulum also swung in favour of the eurozone. Fickle US policy has meant the eurozone is emerging as an attractive alternative for investors over US assets. Meanwhile at the NATO summit, notwithstanding the Spanish exemption, the continent displayed much-needed unity by agreeing to ramp up of core defence spending to 3.5% of GDP over the next decade.

Despite the positive sentiment, growth in the near term is likely to be hit hard by US tariffs, before picking up again in late 2025. The positive contribution from trade frontloading in Q1 is already unwinding according to the April trade data. Supply chains also seem increasingly affected by tariff uncertainty, leading to for instance disruptions at ports. Furthermore, trade diversion is taking place with anecdotal evidence of Chinese steel (over)supply hitting eurozone markets. As the frontloading boost falls away in Q2 and external demand wanes, we expect the eurozone economy to contract (we have pencilled in -0.2% q/q, mostly driven by a sharp contraction in Ireland, and with high uncertainty). The uncertainty around trade is compounded by broader geopolitical uncertainty, which is weighing on consumer and business spending decisions. This keeps a lid on the recent and future driver of growth – domestic demand – at least in the near term. Further out we are more constructive on eurozone growth. Rate cuts are continuing to support higher lending, real incomes and fiscal spending are rising, with the latter especially in Germany raising the growth outlook (see this month’s Global View).

The weakness in the near-term alongside upside risks to the medium term complicates matters for the ECB. Inflation on target at 2% in June and set for an undershoot in the coming months, alongside an unfolding hit to trade suggests the ECB has further to go with rate cuts. Core inflation is expected to hold steady around 2%, but as the ECB confirmed in its latest strategy review on 30 June, “large, sustained deviations of inflation from the target in either direction” are undesirable to the extent that they impact inflation expectations. At the same time, growth faces upside risks from German fiscal policy in the medium term, and with regards to inflation expectations, a period of below target inflation probably wouldn’t be a bad thing given the upward price shock we have just emerged from. At the press conference President Lagarde hinted at a July pause signalling that the ECB was ‘well positioned’ to face the coming period of tariff impact and uncertainty. We think the ECB still has more to do, with the next rate cut expected in September, and likely one last cut in Q4. But the risks are clearly shifting, and the Governing Council may well opt to look through the tariff induced weakness if it is confident enough that domestic demand will overwhelm the weak external sector.