Sian Hurrell
Welcome to Strategic Alternatives, a podcast series from RBC Capital Markets. I'm Sian Hurrell, Head of RBC Capital Markets Europe, and Global Head of Sales and Relationship Management here at the bank. In today's episode, we're turning our attention to the economic outlook for Europe and the United Kingdom, a region that continues to evolve in ways that are reshaping markets, policy and current priorities. As we look ahead to 2026 there are signals of progress in some areas, alongside some challenges that continue to influence the pace and texture of the recovery. Across Europe there are important questions around how growth will unfold, what's driving regional differences, and which factors, whether structural, cyclical or supply side, will matter most in the year ahead. We're going to explore how central banks are approaching the next phase, how fiscal choices are influencing expectations across major economies, and how evolving labor market dynamics in the UK in particular may shape policy debates going forward. From my seat, leading our business across Europe means not only following these developments, but understanding how they intersect with client needs, cross border flows and the opportunities emerging across both the Sterling and the euro market.
Sian Hurrell
That forward leaning perspective, connecting macro signals, market structure and client strategy guides how we're helping clients navigate this environment and how we think about the period ahead. We'll also consider how global dynamics are influencing Europe's economic positioning.
Sian Hurrell
So, joining me today to delve into it all are Peter Schaffrick, our Chief European Macro Strategist, and Cathal Kennedy, our Senior UK Economist. Peter, Cathal, welcome to the podcast.
Peter Schaffrick
Thank you, Sian.
Cathal Kennedy
Hi Sian, thanks for hosting us today.
Sian Hurrell
Peter, let's start with the big picture. As you look ahead to 2026 what are the key themes that you think will shape the economic outlook for Europe and the UK, and how do you connect to the major forces
that we've seen this year, including the renewed focus on us tariffs and their impact on the EU and the UK?
Peter Schaffrik
Yes, sure. Thank you, Sian, I think that's a good way to start. Well, look the way we look at Europe and actually Europe as a whole, and it's not that dissimilar to some other developed countries outside of the US, is that our trend growth rate is relatively low. And it's really important to understand that. When you think about it, over the last couple of decades, our trend growth rate has always come down, but it had stayed at decent levels. Now we've probably declined in the euro area to something like one to 1.25. In the UK, maybe a little bit higher, let's say one and a half. And the main reason for that is that our productivity growth has come down. Now, again, I really want to emphasize that. Now, productivity growth, what does it mean? It basically means getting better with a certain set of resources that you have. And let's face it, frankly, over the last few years, we simply haven't gotten better. We're basically at stand still, and in some countries, we even had negative productivity growth. Now that's a major drag on our performance. Now the good news is that there are some forces at work that push us above that trend, and I think that has also major ramifications, and that's particularly for the euro area, I must say. And I think that has also major ramifications for financial markets. But also, turning to the other part of your questions, the international dimensions here. It's actually interesting that the tariffs have been surprisingly well managed from the European side of things. When we look at, for instance, import prices into the US, they haven't dropped all that much, and our economic performance hasn't been really dented. I mean, we saw a bit of a time shift. Q1 was very strong. Q2 less so, as people were front running the tariffs. But by and large, we've essentially overcome that threat. Now the other big, major force that I would mention is probably more important for us here in Europe is China. China is growing very slowly for Chinese standards, but has increased its production capacity and is now competing in our export markets in a lot of products and areas that European companies tended to be good at, and that's really taking away from our growth as well. It's probably one of the reasons why our trend growth is low. So, I'll probably leave it there, but hopefully that sets the base for sort of a broader discussion, and it's a good starting point.
Sian Hurrell
Thanks, Peter. You spoke a little bit there around growth, but how might the euro area have a comeback in growth, even on a modest level, and what might they need to do to drive that type of improvement, and maybe you could think about how that might influence the ECB path on rates from here.
Peter Schaffrik
So, in the past, the euro area in particular, used to be quite driven by our external sector. So, we were basically exporting. And if the global economy was doing well, we were exporting a lot, we were doing well, and vice versa. Now that has changed quite dramatically. So, our growth is much more homemade. So that's a good starting point, because that also means it's much more under European control. So, when you look at, for instance, domestic demand, domestic demand has been quite strong. We had very low unemployment, we had decent wage growth, and people have been spending. And, actually, we think going forward, they're probably going to spend even more, because a good part of these wage gains, were saved. We've got a relatively high saving rate, but that's coming down, so that's a good starting point. And we don't think that the labor market is going to wobble a great deal. And as a consequence, we think that part is going to be there. Now the second part, of course, is the fiscal expansion. A lot of countries are quite fiscally constrained. The one country that isn't, is Germany, and that's the largest economy in Europe. And even though it has other challenges, the one challenge it doesn't have is fiscally. And as a consequence, what we're seeing is the German budget is going to expand, and we think in ‘26 in particular, that will really drive growth in the country, but also in the euro area, and it will be broadening out. Now I want to make one last point before I quickly say something about the ECB. The Holy Grail is going to be whether or not we can pull in private sector investment, which so far has remained relatively tepid, but also there we are much more optimistic going forward. So, I think there's a foundation here for cyclical growth to be quite decent going into ’26.
Now, you asked me also about the ECB. I think what that means is the ECB has been quick in cutting rates. We're already at two, that is generally accepted as neutral, and we're probably still seeing the positive impact of reduced rates coming through, let's say, in mortgage approvals or in other lending data, and that will also help us in ’26. So, our view is that the ECB is done cutting rates. They won't be hiking anytime soon, but we think they will be on pause probably throughout ’26.
Sian Hurrell
That's great. Thank you, Peter. Cathal, maybe we can turn now to the UK. Are there any similarities between the euro area and the UK. And how do you think about the growth prospects for the UK?
Cathal Kennedy
Peter, in his opening remarks there, mentioned trend growth and the importance of it in terms of where we find ourselves in Europe at the moment, and this is probably the big similarity, if you will, between the UK and the euro area, is this diminished ability to grow. These lower potential growth rates that we now have, in essence a lower speed limit, if you will, for our economies. And in both jurisdictions, a key driver of that has been productivity. Productivity growth, already damaged by the financial crisis, has come down again post pandemic. So, if you just look at longer-term growth rates in the UK and euro area in roughly the 10 years before the financial crisis, the UK grew by about 2.75%, euro area by about 2.5. Post-pandemic, both have averaged about 1% per annum. So again, this lower trajectory for growth, and beneath that, this lower potential for us to grow. I think this is key for us, and this is key to how these slow growing economies can generate inflation. As I mentioned before, the speed limit is now just lower. What's behind this? Well, we don't really know. Lots of factors. We think kind of your post pandemic, it reflects just some of the sectoral growth we've seen in employment. In particular, we've seen public sector employment lead overall employment gains. Public sector productivity tends to be lower than that in the private sector. But over a longer-term perspective, we also see the lasting impact of the financial crisis, particularly on investment. Productive investment in both the UK and euro area has been weakened by the financial crisis, a bit weaker post financial crisis than previously. If you look at the fiscal strategies, if you will, in both the UK and euro area, particularly via Germany, you see now an attempt via fiscal policy to correct some of that, if you will, longer term in nature, but again, trying to correct some of that under investment we've seen over the past 15 years or so.
Sian Hurrell
It feels like, you know, we're reaping some of those dividends in terms of both investment and productivity growth post financial crisis. We've obviously just had the UK budget. That would arguably have delivered modest fiscal tightening. How does that play into that near term view for the UK?
Cathal Kennedy
Well, I think this budget was primarily about stabilization. Now, something we've advocated for some long time is that it was important for the Chancellor to build in more headroom into her fiscal plans, essentially, so we can escape this kind of six monthly cycle of uncertainty we've seen over the last year or so in the UK. So that extra headroom allows for some slippage in terms of the kind of fiscal plans, but more importantly, means we shouldn't have to go through all this in the spring, or possibly even if we get lucky, this time next year again. Now it doesn't do much for growth in the near term, with a little bit of a loosening up front, the tightening you mentioned is kind of postponed to the latter years of the forecast. So we've 26 billion in tax increases, but three quarters of that have come in the last two years the forecast, if you will. So in the near term, growth impacts are fairly marginal. The overall stance of the UK fiscal policy is contractuary. But I think it's important to note that one of the reasons why I call it as a stabilization budget is it's also protects the strategy, if you will, that the government put in place at the budget last year, which was around boosting investment spending in the UK, trying to correct that longer run underinvestment we've seen, we've seen in The UK economy. Now, the impact that's fairly modest, 1% of GDP per annum, and the payback is also longer. So in terms of the here and now, the best thing the budget probably does for near term UK growth is lifting the uncertainty, lifting the fiscal fog, if you will. That sort of uncertainty that has perhaps kept household savings rates high, that has kept business investment low as we've waited to see what tax rises may come as we have this three, four in one period of speculation in the run up to budgets.
Sian Hurrell
Yeah, and we certainly need that period of stability and more certainty, and as you say, to encourage both personal and business investment. Let's just, if we can, for a moment, zoom in on the Bank of England, and you've just lowered your bank of England call. Can you talk a little bit around what drove that shift and where you see the balance of risks now?
Cathal Kennedy
So just to make clear, we did that before the budget, and quite neatly, the budget neither stood in the way nor has it encouraged the Bank of England to go faster than it probably was intending to beforehand. Now, over the course of this year, the Bank of England did largely as we expected it would do. Until recently, it cut at a quarterly pace. By the end of this year, we expected to have delivered 100 basis points of cuts in total. But it has tried to characterize the Bank of England's approach to easing policy thus far as being cautious. And again, to return to the supply side of our economies, we think that one of the reasons for that was the damage the pandemic did to labor supply in the UK. And the big change in the UK economy over the last year has been the loosening in the labor market that we've seen. The unemployment rate is now 5%, up from a little over 4% a year ago. Changes we saw on the budget last year to employ our national insurance contributions have mainly transmitted via reduced hiring. So we now have vacancies below where they were pre pandemic. On the flip side. We've not seen mass redundancies. Employment levels, employment rates have been fairly stable. But digging deeper, what you see is a genuine improvement in labor supply. So the participation rate has recovered to essentially where it was pre pandemic. It's taken almost four years, five years for it to do so, but we finally got back there. And this is key because the post pandemic story of the UK labor market was as much one of weak labor supply as it was one of strong labor demand. And so that labor supply has now come back in. We think, for the Bank of England, that makes its job slightly easier. I mean, you're seeing that loosening in the labor market feed into wages now. And I think as it does so, loosening labor market, slowing wage growth, the Bank of England can feel more confident going forward, that should feed into services inflation, which is what's been its focus now for a couple of years. So I think yes, the labor market has loosened, and I think it's where that loosening has come from it was a catalyst for us to lower that Bank of England call.
Sian Hurrell
That's great. Thank you. Now, Peter, maybe we can bring you back in here and just shift the conversation a little from the economy to markets. And 2025 was a reasonably difficult year for bonds, even with central banks cutting rates. And you've called this in the past the ‘inverse conundrum’, tied in part, to rising long end yields. Can you maybe walk us through a little bit what you mean by that, and what could that signal for us going into 2026?
Peter Schaffrik
Well, first of all, I guess using that phrase probably shows I'm a little bit long in the tooth, because obviously it’s the inverse of the Greenspan years, when he was hiking rates and the long end wouldn't follow. Now we've got the inverse, where central banks have been cutting rates, but long end rates haven't really come down. Now we think this is one of the key features, particularly for the European markets, and we've seen it in most markets, but particularly in the Euro market, and also to some degree in the Sterling market. What we've seen is, essentially the term premium has really returned in those markets. After the QE episodes and the long years of zero interest rates, the term structures were very, very flat, and now as rates then initially went up, they even inverted. But what hasn't really happened is that the risk for longer dated securities hasn't really been rebuilt. And that really started as a combination of higher interest rates, higher inflation, then QT policies, where the central banks let go of the bonds that they held that originally compressed all these term and risk premia, and that has really led to the fact that despite in ‘25 front end rates coming down, central banks cutting rates, we have seen essentially a bearish duration environment. In my mind, A, that's probably going to repeat itself, particularly in the Euro market, where the ECB is probably going to QT for years to come. But also it's not an environment as we just described, where the economies are going to collapse, and therefore you really want to rush into fixed income assets. So, it's probably going to be another very difficult year for duration assets.
Now, one of the flip sides of that is and that we still have fixed income investors who want to buy yield, but what they're doing is they're going, they're going into short duration assets with credit spreads. And one of the other outcomes out of this environment that we're seeing is that credit spreads are really tight. And in an environment where the economy is going to do okay, credit spreads are probably going to stay tight or even tighten further as people seek yields but don't want to buy duration, as the yield curve is still not steep enough, and that's obviously for corporates in particular, a good environment, because as corporate spreads are low, it improves their funding position. So, we think that's one of the positive outcomes of this development, even though, again, for everyone who wants to buy long duration assets, I don't have a good message for ‘26 I'm afraid.
Sian Hurrell
Thanks, Peter. So good for credit, but not for duration. Cathal how does the picture look in the UK? Are you any more constructive on the UK gilt market?
Cathal Kennedy
Yes, in short. Sian, look, I think I mentioned about the budget. One of the positive aspects was that building in of more headroom takes away near term risks, should reduce the kind of risk as we go into future UK fiscal events. So, in short, peak gilt issuance should be behind us. You see that kind of happening almost immediately, going into the kind of the last quarter this year, but also in the first half of next year. Guilt issuance about 10 billion, a quarter lower than it has been in more recent quarters. So that's a positive from the budget. We think the bank could potentially cut two more times in the first half of next year to leave rates at 325, by the middle of next year, I think the markets currently pricing in a currently pricing in a little bit below 350 for the middle of next year. But I think one key catalyst for that will likely be, for the last couple of years, the UK has been something of an exception in terms of inflation. We saw inflation kick back up last year, even as it came down in the euro area. But a lot of what drove inflation higher this year drops back out into April next year. That, along with some measures that were announced in the budget, should, like I said, make the UK look that little bit less exceptional on inflation, should kind of clear the pathway, if you will, for the Bank of England to ease, as we expect, down to about 325 next year.
Sian Hurrell
That's great. So, Peter, let's turn to you for the last question of the of the podcast. You've given us a sense of your outlook for both duration and for credit. You know, obviously this year, credit did outperform. Equities were strong. I'm just interested in your thoughts on trends in 2026 for any other asset classes, and specifically, perhaps on FX, and what your FX views are in both euro and Sterling, yeah.
Peter Schaffrik
So maybe, if I start at the beginning. I mentioned already, credit is probably going to do well again. That's going to be helpful. Rates are probably not going to do so well, as I also mentioned, particularly long end, ultra longs in particular, are probably going to struggle. But the riskier assets are probably going to do okay. We've got an environment where we have growth, and that's not bad. European equities, relatively speaking, are still, I don't want to call them cheap, but certainly not as expensive as they are in other places, certainly in the U.S. So that's helpful. Our colleagues in the US are quite constructive on the U.S. market, and that's typically a very good predictor of where the European equity markets are going as well. So that should be helpful as well. So, I'm reasonably optimistic that we can have decent return there as well. Now the one thing I would point out, and that's particularly relevant you asked me about the facts for our currencies: I mentioned that we have trend growth that's low, and even though we're punching above that, the overall growth level is still moderate. It's almost certainly going to be lower, let's say, than it is in the U.S. And that's one of the things to consider. So, we think, for the FX picture, our growth rates, our attractiveness for capital from the outside, is probably not strong enough to really warrant big inflows into these markets as of yet. That might change, maybe going into ‘27 or ’28. But in ‘26 alone, that's probably not good enough. So the outlook for, let's say, Euro, dollar or cable (GBP/USD), probably is determined by what the dollar is doing. We do have the view that there is going to be more FX hedges being put in place, that they're on balance, people who are still very, very over invested in US markets, which try to diversify a little bit more, and that should put some downward pressure structurally on the dollar, and by extension, then lifts, let's say Euro-dollar for instance. But it's not necessarily, at this stage, a particularly strong Euro story, I just would like to point that out. But yes, we have higher Euro-dollar view, for instance, or indeed, we also see cable strengthening against the dollar, although within euro-Sterling, for instance, we do think that the Euro is probably going to do better than Sterling. Last but not least, I would raise one point where we also think a big question mark in the global markets will be raised is where Asia fits into that. Because one of the things that's definitely true is that the renminbi is relatively weak. Other Asian currencies are relatively weak. We think here a depreciation of European currencies against Asia would absolutely be warranted. And it's certainly a view that we at RBC are proposing.
Sian Hurrell
That's a great point to end on. Thank you both. I've really enjoyed the conversation with both of you.
Peter Schaffrick
Thank you, Sean.
Cathal Kennedy
Thanks, Sean.
Sian Hurrell
Thank you for listening to Strategic Alternatives, the RBC Capital Markets podcast. This episode was recorded on December 3rd, 2025. Listen and subscribe to Strategic Alternatives on Apple, Spotify, or wherever you get your podcasts. If you'd like to learn more or to continue the conversation, please visit rbccm.com/strategicalternatives, or contact your RBC representative.
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