
By Katharine Neiss, PhD, Deputy Head of Global Economics and Chief European Economist, PGIM Fixed Income
Tariff uncertainty has rattled business sentiment and dented investment plans, but consumption is stabilising amidst the real-income recovery from the post-COVID cost-of-living shock.
Our base case is for major economies to “muddle through” the wide-ranging shocks to the global economy. Longer term, it’s a scenario that is consistent with the emergence of a multi-polar world.
Given its comparable economic size, level of development, and established institutions, Europe offers an alternative. That said, key gaps around the region’s depth of capital markets remain a barrier.
US and Euro area converging growth paths
At 2.8%, U.S. real GDP growth in 2024 was more than three times faster than growth in the euro area. This underpinned the narrative of exceptionalism. The GDP growth pattern reversed in Q1 of this year, with the U.S. contracting and the euro area registering a 0.6% quarter-over-quarter growth rate.
The difference largely reflects the frontloading of trade. Our view remains that growth in 2025 will generally converge at just above 1% in most major developed economies.
Although labour markets are easing, their resilience remains key. This resilience is underpinned by structural labour market improvements in several euro area economies, the outperformance of peripheral economies, such as Spain and Greece, and Germany’s ramped-up spending on defence and infrastructure. These factors culminate in a relatively positive outlook for the euro area.
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Our view is that the ECB is likely to lower rates marginally further in 2026 absent any marked deterioration in the labour market. In a scenario of deteriorating labour conditions and inflation credibility holding around the 2% target, the ECB has the space for more aggressive cuts if needed.
The ECB’s policy flexibility contrast to the Federal Reserve
An airgap remains between recent U.S. inflation prints of around 2.5% and the 2% target. Moreover, U.S. tariffs applied to final consumption goods coming from Europe and China pose risks to the inflation outlook that are not mirrored elsewhere.
Our base case assumes U.S. inflation will rise further above target and closer to 3% within 12 months. As such, the Fed is expected to remain on hold for now. We see two more 25 bps cuts over the next 12 months as the most likely outcome.
The bottom line is that U.S. policy space looks more limited than in Europe, and the risks of above-target inflation are greater. These developments have surfaced alongside increasing questions over U.S. institutional credibility as well as general investor attractiveness over and above fiscal sustainability concerns.
For example, as a multinational institution, the ECB is arguably the most independent major central bank in the world. This stands in contrast to recent perceived threats to Fed independence and the prospect of an early replacement of Chair Powell. The EU is also a much more open economic region, with significantly more trade agreements than the U.S. As a result, more traded goods are invoiced in euros than in U.S. dollars. With that said, the size of Europe’s capital markets remains a limiting factor and will ultimately curb the extent to which investors are likely to disengage from U.S. markets.
Japan – delayed return to normalisation
At its June policy meeting, the Bank of Japan held rates at 0.5%, but the tone and signalling was more dovish than expected. The Japanese economy continues to reflate, but nervousness around trade uncertainty has cooled enthusiasm for near-term normalisation.
Trade uncertainty and tariff effects are expected to filter through to the macro data. A key concern is the potential squeeze on corporate profits from higher-than-expected U.S. tariffs, which could translate into weaker pay growth going into 2026. This dynamic would threaten a self-sustaining convergence to the 2% inflation target. As a result, we expect the Bank of Japan to remain on hold for the remainder of this year.
That said, the dynamics of the Japanese economy continue to hold up. Resilient labour markets and recovering real wages are true for Japan as well. Consumer demand remains an important contributor to our outlook of acceptable growth of 1.1% in 2025. Inflation remains robust by Japanese standards, underpinned by high food prices. This suggests that as uncertainty potentially recedes next year, we expect the Bank of Japan to return to its normalisation path.
China – emphasis on the domestic
In China, the managed deflation of its real estate bubble continues. Property investment continues to decline, and house prices have fallen further. Credit demand, including total social financing, remains weak. In the past, this would have signalled a challenging outlook given the tight link between credit expansion in China and GDP growth.
However, government support aimed at the consumer, such as trade-in incentives and e-commerce discounts, have provided economic support. The Geneva trade truce offered another near-term fillip to the economy, though industrial production and fixed asset investment remains weak.
This weakness undoubtedly reflects the newly erected trade barriers, not just from the U.S. via higher tariffs, but also from the EU, which recently launched an import surveillance task force to monitor potentially harmful import trends. Alongside targeted fiscal support for consumers, China is also benefiting from monetary easing. Inflation remains below zero, and even recent oil price volatility is insufficient to overcome deflation. As a result, we see further easing in the second half of 2025.
This policy easing should also bolster emerging market (EM) economies and reinforce the narrative of enduring EM resilience.