Economics Update October 2025 - Europe at a crossroad – 2026, a fateful year

Until February 18, investors were able to enjoy an increase in the value of European equities of almost 13 percent since the beginning of the year. At the same time, US equities were up only 4 percent. In the nearly ten months since then, the pattern has reversed: European equities have virtually stagnated, while US equities have risen by 10 percent.

This development reflects the current situation in Europe very well: the decisive factor for the good performance of European equities at the beginning of the year was the expectation that the new German federal government would tackle the challenges facing Europe (and Germany) better than the previous traffic light coalition government. This assumption was initially fulfilled: First, it held out the prospect of a significantly more expansionary fiscal policy with the softening of the debt brake and the planning of new special debt. Positive effects on aggregate demand and thus profit opportunities for European companies were therefore inevitable. Second, Chancellor Friedrich Merz personally made intensive efforts to revive European cooperation, particularly the German-French axis.

At the latest with what US President Donald Trump called “Liberation Day” on April 2, it also became clear that the challenges for European politics are continuing to grow. 15% import tariffs imposed by the US, the threat of further rounds of tariffs (e.g., on pharmaceutical products), the ongoing war in Ukraine, Russian drone attacks, and fundamental doubts about the reliability of the US as a strategic partner: time and again, European deficits became apparent, and the need for political action became increasingly clear. It was therefore hardly surprising that international investors switched to a wait-and-see mode to see whether politicians would respond to these necessities.

The answer so far has been a very clear “no.” In German financial planning, investment spending in the federal government's core budget will fall by €16 billion per year in the coming years – so special-purpose debt on this scale merely serves to plug holes in the budget and avoid necessary structural reforms. As far as the latter is concerned, there is no shortage of declarations of intent and long lists of individual measures to reduce bureaucracy and promote digitization. Commissions are to be set up to reform the social security systems. Tax relief for citizens and businesses, on the other hand, remains a distant prospect. What is still lacking is a clear signal, credible to stakeholders, that the government intends to unleash growth forces and put distribution discussions on hold for the time being. The continuing poor mood is likely to have its main cause here.

Europe must decide

The situation is no better at the European level: European politicians' declarations of changed priorities have so far been followed by neither concrete ideas nor pan-European initiatives. How European security against external attacks can be quickly restored, how the huge backlog in artificial intelligence and digitalization can be reduced, how strategic dependencies can be eliminated, how opportunities for start-ups can be improved, and how a unified European capital market can be created—all of this remains largely unclear. Just a few days ago, former Italian Prime Minister and former President of the European Central Bank Mario Draghi summed this up by saying that the European growth model is continuing to lose importance, weaknesses are increasing, and there is still no clear way to finance the necessary investments.

2026 could be a fateful year for Europe: either it will succeed in tackling the challenges constructively, with a clear focus on competitiveness and defense capabilities, the further development of the single market, and a fundamental reform of European decision-making mechanisms. This would result in a sustained, strong upturn, which could also make European equities the (surprise) winners of the year. Or Europe will be left behind for good and become a pawn of foreign powers with no role of its own in the emerging world order. Continued unsatisfactory performance of European equities would then probably be the least of its problems. There is likely to be little room for compromise – Europe, its governments and ultimately its citizens will have to make a decision.