Europe battles to unleash growth and innovation

President-elect Donald Trump’s sweeping comeback and his threats of trade tariffs have undoubtedly shaken investor confidence in Europe. This, coupled with Germany and France’s domestic issues, poses real challenges for the continent’s economies and markets.

A recent recurring narrative has been Europe’s persistent lagging behind its longstanding ally, the US, hampered by lack of political will. The recently published Draghi Report, which laid out a strategic framework to bolster Europe’s economic standing and avert stagnation in the face of intensifying global competition, is seen as a hopeful sign by investment experts.

A key recommendation of the report is reducing fragmentation of the EU’s capital markets. Authored by former European Central Bank president Mario Draghi, it proposes creation of a European Securities Exchange Commission to oversee major markets and issuers, aiming to facilitate more effective financial intermediation and encourage cross-border investment.

The report stresses that private sector investment alone will not suffice. Public sector involvement is crucial to meet Europe’s investment needs, highlighting necessity for coordinated efforts to drive growth and innovation.

Mr Draghi advocates for targeted policies across vital sectors such as energy, pharmaceuticals, AI and transport. He also calls for broader initiatives in areas like innovation, skills development and governance, underscoring their importance in maintaining competitiveness with the US and China.

But maintaining that competitiveness with the US may be challenging now that Mr Trump is set to take office. The potential policy direction, reflected through his personnel choices, signals a commitment to fulfilling campaign promises focused on reducing “moral hazard” in global trade and alliances, as Arnab Das, global macro strategist at Invesco, puts it. This approach could lead to renewed trade tensions, particularly impacting allies such as Europe, Japan, Canada, and Mexico, while China remains a key target among adversaries.

For Europe, the implications are significant. “Retaliation is likely once again, as in the first Trump term,” says Mr Das. “The world’s surplus countries, including the eurozone — and China too — will likely suffer a growth hit or a hit to corporate profitability because it is very hard to see how the surplus countries will redirect trade to other countries, especially if the US also tariffs exports from countries benefiting from trade diversion, such as Mexico or Vietnam.”

New hits for Europe

Europe should expect to face “new hits” on top of “elevated” energy import costs, “strong” competition from China through lower exports or export revenue, reflected in a weaker euro, as well as the “threat” of hits to net trade and domestic revenues in manufacturing.

Mr Das recommends Europe needs to relax fiscal rules, regulations and social protections. He believes deepening the single market and advancing toward a fiscal and political union — including full integration of banking and capital markets — would enhance competitiveness.

Such steps would also strengthen Europe’s resilience against external pressures, making it more difficult for the US or China to exploit divisions by offering incentives including electric vehicle investments, or imposing targeted trade barriers. But that is easier said than done. “Sadly, none of this seems likely to be done expeditiously, comprehensively or in a sustained fashion, given the multiplicity and conflicts of national interests across the eurozone and EU,” says Mr Das.

Following the collapse of the three-party coalition of Germany’s Olaf Scholz, Europe’s largest economy is heading to the polls early next year.

Support for the three ruling parties is waning, with the centre-right and far-right parties gaining momentum. Friedrich Merz, once a prominent rival to former Chancellor Angela Merkel, has emerged as a key figure for Germany’s conservative Christian Democratic Union (CDU). He now aims to challenge Chancellor Olaf Scholz and position himself as the country’s next leader. Some experts see the election outcome as a catalyst.

“We know that Friedrich Merz seems keener now to lead a more stimulative fiscal policy,” says Benjamin Melman, global chief investment officer at Edmond de Rothschild Asset Management. “It seems he is more ready to accept an investment plan for Germany.”

However, there are still many questions about investment plans and whether there is enough “political will” to implement such proposals.

“The rise of extremist parties, often opposed to the EU, not only proves the frustration among the population, but is also reduces ability to deal with weaknesses of the European model,” says François Savary, former chief investment officer at the Geneva-based private bank Reyl, now running his own wealth management firm, Genvil.

The Draghi Report, he believes, could represent some hope for the continent. However, nothing has been decided yet. “Time is of the essence for Europe, let’s hope the German government that will be elected in February 2025 will endorse the idea of further integration,” he says.

Ukraine crisis

Another catalyst could be Ukraine. “No one knows what’s going to happen with Ukraine,” says Mr Melman at Edmond De Rothschild. “A ceasefire in Ukraine would lift European sentiment.”

Mr Trump frequently boasts about his opposition to war, claiming that conflicts like the one in Ukraine would not have happened under his leadership and that he could potentially end hostilities in one day. However, a rapid resolution would, in reality, necessitate serious negotiations toward a ceasefire, truce, or armistice, ultimately culminating in a formal peace agreement.

“Russia’s progress and Ukraine’s difficulties suggest that a land-for-peace deal is conceivable,” says Invesco’s Mr Das. But for this to be “sufficiently attractive” to Russia, which is gaining ground, in what seems to be a war of attrition, presumably “some carrots” would be necessary – such as a reduction or removal of sanctions.

Mr Trump’s goal of ending the war quickly could potentially involve a partition, alongside EU membership without Nato membership, plus an EU-financed set of security guarantees to help maintain stability, believes Mr Das. But it must be based on Europe more evenly sharing the burden of its regional security and defence, he suggests.

Last minute Europe

Investment experts are still undecided as to who will spearhead Europe’s revival. Political turmoil in Germany and France, coupled with their respective economic hurdles, risks undermining Franco-German leadership and could hinder the EU’s ability to maintain a unified stance in critical negotiations.

Stars are not aligned, as Mr Melman of Edmond de Rothschild puts it. “It’s difficult to know who will take the lead and who will be the engine, possibly the next German chancellor, but it’s very difficult to know,” he says, though Europe “knows” it needs to do something.

“It’s at the last minute that something happens in Europe,” he says with a sense of optimism.

While acknowledging that the US tends to do better than Europe when it comes to innovation, Mr Melman stresses that Europe must build a more robust market of capital. “If Europe succeeds in that field, it will be better for innovation.”