Lower interest rates helped economic activity and supported real estate markets

The EU economy experienced moderate but consistent growth of 1% in 2024, with inflation declining from 5.4% in 2023 to 2.6% in 2024^[11]. Lower inflation has enabled central banks to loosen their monetary policies. Since May 2024, the European Central Bank (ECB) has reduced its policy rate on eight separate occasions, and as of June 2025, the deposit facility rate stood at 2%. Additionally, numerous central banks in Member States outside the euro area have followed similar monetary policy paths, with Poland implementing particularly significant reductions, amounting to 100 bps in 2024. Besides central banks’ rate cuts, the euro yield curve steepened, for instance, not least because of the adjustments in ECB rate policies, reduced expectations for further rate cuts, along with structural inflation risks and higher government bond supply^[12].

Lower borrowing rates have benefited the economy by reducing the cost of loans, thereby encouraging corporate investments and consumer spending, which was additionally supported by a strong labour market. As of March 2025, the unemployment rate in the EU was 5.8%. In the euro area, the unemployment rate was slightly higher, at 6.2% in March 2025, a decrease from 6.5% in March 2024.

A robust labour market and lower interest rates have supported the real estate market, especially in the second half of 2024. The residential real estate (RRE) markets in Europe demonstrated a significant improvement in 2024, underscoring the resilience of the sector. The demand for housing not only reflected the lower interest rate environment, which reduced some financial pressure on buyers, but also the continued shortage of housing supply, particularly in urban centres^[13]. Cognisant of the low transactional activity, which may misrepresent prices, commercial real estate (CRE) prices stabilised in the course of 2024. In broad terms, market sentiment has improved due to lower interest rates, but the sector still faces broad structural and cyclical challenges, including lacklustre demand for certain sectors (e.g. offices), refinancing and debt management challenges, rising construction costs, as well as buildings’ climate resilience, for example.

Geopolitical developments weigh on macroeconomic projections

Heightened geopolitical tensions, including war and political tensions in Europe and other parts of the world, and the related domestic and global policy uncertainties, contribute to macroeconomic instability^[14]. This is perhaps even more pronounced in regions with critical energy resources or significant trade routes, further aggravating the downside risks to economic growth. Conflicts and political instability can lead to abrupt disruptions in energy supplies, causing spikes in energy prices. Such volatility can not only affect the cost of living but also the overall stability of markets. For instance, the conflict in the Middle East has led to elevated freight costs and energy prices, which, in turn, contributed to inflationary pressures. Furthermore, policy changes announced by the new US administration have created additional uncertainty regarding future trade directions. An increase in trade frictions may negatively impact global growth by increasing costs, disrupting production, and forcing adjustments to supply chains. Moreover, retaliatory measures may further diminish the benefits of free trade and exacerbate these dynamics. Consequently, the risks to economic growth and inflation are closely tied to escalating geopolitical developments and potential trade disruptions.

Although current forecasts from the European Commission and the ECB indicate that the EU economy and the euro area will see a slight acceleration in economic growth in 2025, with further reductions in inflation, these forecasts are coupled with high uncertainty, as future geopolitical developments may have a major impact on them^[15].

These combined factors, trade frictions and geopolitical tensions, create an environment of uncertainty that erodes business and consumer confidence^[16]. When confidence is diminished, investment and consumption both tend to decline, thereby slowing down economic growth further. Firms may delay or reduce capital expenditures, and households might reduce spending, anticipating more challenging economic conditions.

Geopolitical tensions have also increased the need for additional defence spending within the EU. This is due to various factors, such as addressing security threats, enhancing collective defence capabilities, strengthening the North Atlantic Treaty Organization’s (NATO) deterrence and response strategies, and keeping pace with technological advancements in warfare, including cyber-attacks and hybrid tactics (i.e. a combination of political, economic and informational tools), which necessitate the modernisation of defence forces. Increased defence spending, however, may also prove beneficial for economic growth as it benefits the EU’s defence industry, promoting innovation and job creation. Such additional investment can facilitate the development of advanced technologies that serve not only military but also civilian applications. It can also foster the EU’s technological and industrial capacity, further contributing to overall economic growth. Furthermore, it partially also comes in parallel with further infrastructure spending.

However, some nations may face challenges in accommodating higher defence budgets without encountering fiscal strain. The EU’s average debt-to-GDP ratio reached 82% in late 2024, showing a further year-on-year increase of 0.1 percentage points. However, there are significant differences between individual countries. EU countries with high public indebtedness may manage increased defence expenditures by improving fiscal discipline, reducing spending in other areas, and implementing measures to ensure debt sustainability. There may be a need for gradual budget adjustments and resource reallocation.

European bank stocks demonstrate resilience during heightened market volatility

Announcements about geopolitical developments, tariffs and fiscal policies prompted strong market reactions and increased volatility on financial markets. Following the announcement of the imposition of additional US tariffs in April 2025, market volatility increased considerably, to levels not seen since the outbreak of the pandemic, and only comparable to events like the Global Financial Crisis (GFC, 2008), and the European sovereign debt crisis (2011). While uncertainty remains heightened and downside tail risks elevated, the announcement of moratoria on the imposition of US tariffs and the commencement of talks between the US and China on trade calmed the markets and normalised volatility.

The market sell-off in April 2025 also impacted European bank equity prices, which have been outperforming other European sectors and their global peers since the beginning of the year. In March 2025, the price-to-book (PtB) index of European banks was reported to be higher than 1, a level not seen for many years, closing the gap with their US peers (Figure 3).

Geopolitical developments have also affected sovereign debt yields. Several EU countries have seen their cost of funding rising, also driven by the need for increased spending on defence. For example, in early March 2025, the yields for German 10-year sovereign bonds increased by close to 25 bps on the announcement that Germany will significantly increase defence and infrastructure spending. Borrowing costs of other European countries increased, too, yet the yields of EU sovereign bonds remain considerably lower than their 2023 peak levels. The rather contained risk premium adjustments, however, indicate that investors broadly see increased defence spending as driver for technological advancement and contributor to economic growth and stability.

Geopolitical developments have also influenced various other assets, affecting overall market sentiment. In cryptocurrency markets, for example, there were significant price fluctuations for major cryptocurrencies such as Bitcoin and Ethereum. Despite some digital currencies recording material gains in 2024, this was followed by sharp declines and a correction in prices, further feeding volatility. Key factors include ongoing concerns about regulatory developments in major markets like the US and the EU. While oil and gas prices were also negatively impacted by geopolitical developments, gold seemed to be again favoured as a safe haven asset.