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Investing.com -- Investor sentiment toward Europe has turned notably more upbeat, buoyed by falling inflation, lower interest rates, and stronger real incomes.
But strategists at Capital Economics warn that this optimism masks a set of deeper, unresolved challenges that will shape the continent’s future. In a Monday report titled ‘The Future of Europe,’ the firm identifies three key questions confronting the region.
The first question is whether other countries can follow Germany’s shift to a looser fiscal stance. Capital Economics is skeptical: “Trying to do so could precipitate national fiscal crises,” particularly in member states already struggling with debt, such as France and Italy, the firm wrote. The outcome will influence whether there is a broader recovery in domestic demand.
Second, Europe faces a structural reform test. The region’s lag in artificial intelligence and other emerging technologies is becoming more pressing. Without reforms, Europe “risks remaining stuck behind the technological frontier,” and rising competition from Chinese firms could add pressure.
The report points to the Draghi Report’s proposals as a missed opportunity.
“The policy response, or lack thereof, will be critical,” Capital Economics stresses.
The third question is geopolitical. Europe aspires to act as a “third pole” amid growing tensions between U.S. and China-aligned blocs. Yet, the economics research firm argues that “the European project isn’t hard-wired to project power – hard or soft – to the extent that the U.S. and Chinese governments are.” Internal divisions continue to limit its global influence.
While the European Central Bank’s expanded policy tools have helped lower systemic risk, the outlook remains fragile. The report cautions that “the recent improvement in sentiment may not be fully warranted.” It adds that Europe is unlikely to catch up with U.S. growth, citing structural disadvantages such as energy dependence and rigid labor markets.
“And the euro still won’t present a meaningful challenge to the dollar’s dominance in the global economy,” the report added.
In the longer term, Europe is expected to remain “a wealthy but relatively slow-growing region,” underperforming in innovation but offering selective investment opportunities.
Capital Economics plans to explore these issues further in upcoming reports covering Germany, fiscal risks, U.K.–EU ties, and the EU’s eastward expansion.