Outlook 2026: European capital markets give cause for optimism
The picture is rosy, though dark clouds loom on the horizon
By Conor Perry
LONDON, January 10, 2025 — European capital markets entered a phase of comparative calm and normalisation in 2025. Looking ahead to 2026, there is cause for optimism, though with some big caveats.
The European Central Bank cut its deposit facility rate during each of the first four meetings in 2025 and then held steady from June. Inflation continued a downward march to hover near the ECB’s 2 percent target and euro area growth is estimated at 1.4 percent. European equities rallied, with the EuroStoxx 600 outperforming the S&P 500. Credit spreads became tighter and bank balance sheets remained healthy. While US trade policy and sustained geopolitical tensions caused some market shudders, and select sovereign debt markets suffered volatility, the picture was mostly bright.
Projections for 2026 are mixed with central scenarios skewed to the upside. Growth appears set to remain above trend and the prospect of the acutely European prognosis of ‘secular stagnation’ has reduced dramatically. Short-term interest rates are likely to remain stable, anchored by the ECB’s policy stance. Long-term interest rates, however, will rise due to a confluence of structural factors. The risks that do pervade are of a systemic nature: a sharp correction in financial markets may feed through to the real economy.
Growth and the fiscal impulse
The ECB upgraded its 2026 growth forecast for the euro area in its December projections to 1.2 percent, up from 1 percent in its September projections. This upgrade reflects a loosening fiscal stance, particularly from Germany with projected investment of €127bn over 2026, as well as strong private consumption and private sector investment, notably in artificial intelligence. The effects of Next Generation EU-funded investment in southern European nations also play a role in the ECB’s outlook.
In 2025, the ECB expects the European Union to have grown by 1.4 percent. Although such growth levels pale in comparison to China’s expected 5 percent growth rate for 2025, they constitute a historically low growth differential with the US, which is projected to have seen gross domestic product expand by just 1.7 percent. They also mark an acceleration from the EU’s historical growth level, which averaged just 0.7 percent from 2023-24. While Europe still has plenty of policy progress to make to allow its economy to flourish, the contours of its growth story in 2026 are reassuringly smooth.
Rates on hold
Derivative markets currently project no change to the ECB’s interest rate policy stance throughout 2026. In the absence of data shocks short-term interest rates should remain anchored near 2 percent. As inflation tends to the ECB’s 2 percent target – the ECB projects 2.1 percent inflation in 2026 – the euro area’s real interest rate will hover near 0 percent. The natural rate of interest, which is neither expansionary nor contractionary, is estimated by the ECB to sit between -0.5 percent and 1 percent, meaning that the ECB’s policy stance is approximately neutral at its current level.
In combination with favourable growth conditions, a stable and neutral interest rate implies a continuation of tight credit spreads. This bodes well for issuance and funding conditions in corporate credit markets, particularly at shorter tenors. While European corporates overwhelmingly rely on bank loans rather than bond issuance, stable short-term rates are nonetheless a supportive backdrop for the European corporate landscape.
The cost of duration
Three structural forces imply an increase in long-term interest rates. First, increased sovereign issuance to finance expansionary fiscal policy and increased defence investment will place upward pressure on the supply of long-dated debt. Second, the transition of the Dutch pension system from defined benefit to defined contribution schemes reduces a source of natural demand for long-dated European bonds. Third, the continued quantitative tightening of the ECB compounds these effects, amplifying the pressure on long-term rates.
Sovereigns are both instigators and victims here. Many national debt management offices will accept an increase in refinancing risk, issuing at shorter maturities to shield their treasuries from the fiscally deleterious effects of a steepening yield curve. While the impact of higher long-end rates will vary with levels of sovereign profligacy, interest payments as a proportion of GDP are likely to rise across Europe.
These effects will feed through to other asset classes priced off long-dated sovereign debt, with mixed economic consequences. In an otherwise bright outlook, yield curve steepening may be the unavoidable yellowing of Europe’s 2026 capital markets.
Faultlines
There are risks to this rosy picture. Elevated equity valuations and subdued volatility, discordant with high uncertainty, is now even of concern to the ECB. Continued geopolitical tensions, notably in Ukraine, as well as a resurgence in trade tensions, could also conspire to disrupt the calm. The most serious risks revolve around banking sector instability caused by a severe economic downturn.
Although banks are well capitalised, concerns abound over the opaque interlinkages between private credit and the traditional banking system. Tariff risks are relevant here due to their potential to harm the prospects of the small and medium-sized firms that form the backbone of the European economy, impacting banks through their direct exposure to such firms in their lending activity, and their indirect exposure through private credit.
Risks are compounded by the rise of synthetic risk transfers increasingly used by European banks to manage capital requirements. SRTs typically operate with non-bank financial institutions, such as a private credit firm, selling credit protection to a bank on a portfolio of assets.
The International Monetary Fund has expressed concern about the capacity for such arrangements to amplify systemic financial risk as the leveraged sellers of protection face margin calls on SRTs precisely when asset values fall. The systemic financial stability risks are compounded when banks are lenders to the same institutions that sell them credit protection through SRTs. Unfortunately, data unavailability constrains access to a full picture of the risks of the market.
Clearly, a number of potentially dark clouds may form over the otherwise gentle landscape of Europe’s 2026 capital markets. Although growth is up and inflation down, faultlines may emerge.
Conor Perry is an economist at OMFIF.
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