Outlook for the 3rd quarter: End of stagnation in the eurozone

Bond markets: Outcome of trade dispute between the US and Europe decisive for interest rate developments

The European bond market calmed down in the second quarter of 2025. Yields on ten-year German government bonds fluctuated within a narrow range between 2.7 and 2.4 percent, while corporate bond spreads remained largely stable. This calm may reflect the fact that Germany is increasingly taking on the role of a safe haven – one of the last remaining safe havens for global investors. Despite the prospect of significantly higher government spending, public debt remains moderate by international standards. At the same time, confidence in the independence and credibility of the European Central Bank (ECB) appears intact: inflation reached the stated target of exactly 2.0 percent in June and, according to the ECB's forecast, could even fall to 1.7 percent in 2026. In a world of fiscal overextension and political fragmentation, such monetary policy discipline is now considered a rare commodity.

The major issue for the European bond market in the third quarter is likely to be the trade conflict between the US and the EU. If a reasonably good agreement is reached that does not cause major damage to the eurozone economy, the ECB could take another interest rate step and lower its key rate to 1.75 percent in September. As this interest rate move is already widely expected, it is unlikely to have a major impact on the bond market. If, on the other hand, the trade conflict escalates, the European economy would face a major setback. The ECB would then have to try to limit the economic damage with several key interest rate cuts. This would result in significantly lower yields and very good performance for government bonds with good credit ratings. Corporate bonds, on the other hand, could perform slightly worse than government bonds, as the economic risks would result in higher spreads. Inflation in the eurozone is falling overall, and the risks of a significant rise in government bond yields are therefore only moderate. Financial markets expect the average inflation rate over the next twelve months to be only around 1.6 percent. This is due to slowing wage growth and a noticeable drop in energy prices.

Stock markets: Investor confidence in the US market remains unshaken

In the second quarter of 2025, US equities celebrated an impressive comeback. The MSCI World Index, which they dominate, gained nearly 10 percent, while the MSCI Emerging Markets Index also performed strongly, rising 8.1 percent. The MSCI Europe lagged behind at 3.4 percent, less due to weakness than to previous gains that reduced its upside potential. The US rally was all the more remarkable given the erratic US trade policy. Washington apparently convinced market participants that it would not tolerate a sharp drop in prices: the postponement of the previously announced tariff increases at the beginning of April reinforced this assessment, and the time gained for negotiations was a positive signal for the stock markets. The euphoria was further fueled by a broad-based tax cut package – the so-called "Big Beautiful Bill." Market participants demonstratively ignored the associated fiscal policy risks. Conclusion: Fiscal discipline counts for little when the political narrative sounds growth-friendly.

Valuations on the US stock market are once again approaching historic highs. According to our calculations, the ex-ante risk premium – the buffer that is supposed to compensate investors for holding equities rather than ten-year government bonds – stood at a meagre 2.4 percentage points at the end of June, well below the long-term average of around 4.75. Investors clearly fear neither macroeconomic turmoil nor political volatility. Instead, they seem to have blind faith that US President Donald Trump – acting as an unofficial "plunge protection team" – will not tolerate any significant price losses. What's more, the ongoing AI hype is ensuring a steady stream of positive news in the technology sector.

In Europe, on the other hand, the ex-ante risk premium is 6.2 percentage points. This is above the historical average of 5.75, measured against ten-year German government bonds. This signals attractive potential, especially as fiscal easing, ECB policy, and the first signs of economic deregulation are harbingers of a rare economic tailwind.

Eurozone economy: between fiscal hope and external vulnerability

Europe has long been written off – since 2008, the continent has been reeling from crisis to crisis, the economy has stagnated, and no significant innovations have been produced. In the summer of 2025, signs of a new crisis began to emerge. But this time, Europe seems to have learned from its past mistakes: While the global economic outlook is clouding over – mainly due to the revival of a US tariff regime that is more reminiscent of the Smoot-Hawley Tariff Act of 1930 than of Bretton Woods – the eurozone is beginning to grow slightly stronger again, quietly and almost unnoticed.

Without the European Monetary Union, currency crises would have been inevitable in many European countries in this environment, as capital would have fled to Germany. The euro has thus become an important anchor of stability for many countries.

In addition, a cyclical upturn is on the horizon, especially in Germany, where a belated but decisive fiscal stimulus package is beginning to take effect. Spain is also surprising with robust growth figures. We expect the eurozone to grow by 1.2 percent this year – not an economic renaissance, but an improvment after years of stagnation.

But the euphoria is muted – and rightly so. The return of US tariff policy could prove to be an economic policy problem for Europe. If US President Trump makes good on his threat and imposes a 30 percent tariff on European imports across the board, this could reduce the eurozone's gross domestic product by an estimated 0.5 percent by the end of 2026. In a region whose economic model is dependent on export surpluses and industrial interdependence, this would not be a mere "technical adjustment" but a structural burden. The ECB would then have to take stronger countermeasures and significantly lower its key interest rate.

At present, however, we still see good chances of a reasonably acceptable agreement for Europe in the tariff dispute, meaning that there will be no major negative effects on economic growth. In this environment, the ECB is likely to cut its key interest rate to 1.75 percent in September.

What remains is a delicate economic policy balance: moderate domestic demand growth is being offset by external threats. Global shocks – whether they come from Washington, Beijing, or the Red Sea – could quickly destabilize this fragile stability. Although the eurozone will have stabilized economically in the third quarter of 2025, it will remain geopolitically exposed. A cautious upturn, fueled by fiscal stimulus and pent-up consumer demand, will be threatened by external protectionist risks. The window of opportunity for Europe to generate its own momentum is small, and it requires a degree of political coordination that is often invoked in Brussels but rarely achieved. The coming months will show whether Europe is capable of regaining its role as a strategic player on the global stage or whether it will once again have to settle for being an economic pawn.

US economy: Between tariff shock, consumer squeeze and political pressure on the Federal Reserve

US President Donald Trump increasingly sees himself as the architect of a new world order. He has now announced plans to raise average US tariffs to levels last seen before World War II by 2026. Specifically, tariffs could rise from around 10 percent at present to almost 20 percent by the end of 2026. From an economic perspective, protectionism is essentially a consumption tax. While traditional taxes make sense, at least from a fiscal point of view, tariffs are a form of self-punishment. They act as a supply shock and are stagflationary.

The current data is therefore as clear as it is sobering: real private consumption has been treading water for six months now, and construction activity is falling faster than at any time since the subprime bubble burst. Real growth in the first half of 2025 was estimated at a meager 1.1 percent. Inflation, driven by the new tariffs, is also sending a worrying signal: the core rate of the Personal Consumption Expenditures Price Index (PCE) is likely to rise above 3 percent again in the second half of 2025 – a level that would not be dramatic in macroeconomic terms if it were not accompanied by weak real incomes. A kind of tariff-induced "inflationary stagnation" is looming, in which higher prices are hitting a society whose consumer spending power is dwindling – not least because of the waning wealth effects caused by weaker stock markets.

In this mixed situation, the labor market is also becoming increasingly fragile. Employment momentum has slowed noticeably, with private sector hiring remaining in the low five-digit range at best. The diffusion indicator – an often underestimated but reliable leading indicator – already points to a balance between sectors with job cuts and sectors with job creation. Immigration, which has almost come to a standstill, is still keeping the unemployment rate stable, but the famous "stall speed" scenario – a sudden tipping of the economy into recession – is dangerously close.

This puts the US Federal Reserve in a precarious position, both economically and politically. Although the latest signals point to interest rate cuts in the near future, there is a real risk that political influences will undermine the credibility of monetary policy: Trump has already expressed his displeasure with Fed Chairman Powell on several occasions and threatened to fire him.

The US economy could therefore become a barometer of geopolitical tectonics. Growth, consumption, employment – all these factors are no longer determined solely by economic fundamentals, but increasingly by political risk premiums.

Asian economy: Trade conflict slows Japan, flood of exports from China

In Japan, business surveys such as the Tankan index and the purchasing managers' indices paint a moderately positive economic outlook. However, sentiment could improve significantly in the coming months as the trade conflict with the US has been defused. Japanese exporters, with the exception of steel and aluminum, now face a 15 percent tariff. The advantage is that the uncertainty is over and planning can now begin. Japanese exporters also appear to be in a better position than exporters in other countries, particularly in the automotive sector.

Against this backdrop, the Japanese yen benefited from an appreciation of almost 10 percent against the US dollar compared with the beginning of January 2025. The Japanese yen thus still enjoys a certain status as a safe haven, and a dangerous downward spiral of the currency appears to have been halted for the time being.

At the same time, however, there was turmoil on the Japanese government bond market. The yield on 30-year government bonds jumped from around 2.25 percent at the beginning of the year to a peak of just under 3.2 percent. There was no clear trigger for the rise in yields. However, it seems likely that higher inflation of around 3.0 percent in Japan, combined with a continuing loose monetary policy, played a role. A key interest rate of 0.5 percent is very low by international standards and means strongly negative real returns for investors.

This will increase inflation risks in the medium term. The Japanese government is issuing fewer long-term bonds, which should initially calm the bond market again. In principle, the Japanese government should actually take advantage of the favorable economic environment to reduce the budget deficit and thus reduce the risks for the bond market.

The imbalances in the Chinese economy worsened in the second quarter of 2025: Although gross domestic product exceeded consensus estimates with a growth rate of 5.2 percent, this was mainly due to the robust development of industrial production and exports. By contrast, the real estate sector remained structurally weak and private consumption was sluggish, apart from temporary support measures such as the "cash for clunkers" program for car replacement subsidies. Retail sales outside these special promotions are stagnating. The result is growing macroeconomic asymmetry: while production is rising, domestic demand is lagging behind. The inevitable consequence is that the current account surplus is exploding – it stood at 4.3 percent of GDP in the first quarter.

What may be a technically "positive" development for China itself is a systemic challenge for the rest of the world. In a world of stagnating growth and rising protectionism, this new Chinese export stimulus is like a second "China shock." A new wave of Chinese industrial goods is flooding global markets, depressing prices and hitting industrial sectors that are already under strain. In Europe, the US and parts of Asia, domestic political pressure is likely to mount to protect domestic markets with protectionist measures – regardless of how ineffective such measures ultimately prove to be. China itself is well aware of this dilemma – and is responding as usual with technocratic caution. The currency remains undervalued, fiscal policy is restrained, and monetary policy is cautiously accommodative. But what is really needed is a fundamental policy shift: a strategic reorientation away from supply-driven industrial and infrastructure promotion toward a sustainable, consumption-oriented economic structure. The political will to do so remains limited, not least because such a structural change would also imply a loosening of political control.