Today, the Governing Council of the European Central Bank announced its decision to keep interest rates unchanged (deposit facility - 2%, main refinancing operations - 2.15% and marginal lending facility - 2.40%), during a press conference held by President Christine Lagarde and Vice-President Luis de Guindos.

The ECB reaffirmed that its primary objective remains price stability, with inflation anchored at the 2% target. We previously explored this on ECBs inflation deviation and monetary policy.

Economic activity

Economic growth remained modest at the end of 2025, with GDP expanding by 0.3%, mainly driven by the services sector, particularly information and communication services.

Unemployment remains low at around 6%, while rising incomes and lower household savings are expected to support consumption. Business investment is also projected to strengthen.

However, the ECB highlighted several global challenges, including:

• trade tariffs

• a stronger euro

• a more uncertain international environment

The Governing Council stressed the urgent need to strengthen the euro area, especially in the current geopolitical context. Governments were encouraged to focus on sustainable public finances and growth-enhancing reforms.

This message aligns with themes discussed in our broader Economic Outlook of Europe - Q1 2026.

Inflation

Inflation declined to 1.7% in January, down from 2.0% in December.

Underlying inflation indicators have changed little in recent months and remain consistent with the ECB’s 2% target. Most measures of longer-term inflation expectations continue to hover around this level, supporting the view that inflation is stabilising.

Risks to the outlook

The ECB highlighted continued uncertainty facing the euro area.

Downside risks to growth include:

• a volatile global policy environment

• weaker global demand

• tighter financial conditions

• frictions in international trade

• ongoing geopolitical conflicts

On the upside, planned defence, infrastructure, and technology investment could support growth more than expected, improving business and consumer confidence. New trade agreements could also contribute positively.

Inflation risks follow similar patterns:

Lower inflation risks

• weaker export demand due to tariffs

• a stronger euro

Higher inflation risks

• supply chain disruptions

• rising energy prices

These themes are closely linked to recent geopolitical developments discussed on our article about the relation between Geopolitical instability and Europe.

Financial and monetary conditions

The average interest rate on new mortgages remained stable at 3.3% in December.

The ECB noted a rising demand for loans and signs of easing credit conditions in parts of the market.

These developments are important for Europe, where bank lending plays a central role in economic activity.

For more context, see our article on the ECB’s financial stability review - november 2025.

Conclusion

The ECB reiterated that future interest rate decisions will remain data-dependent and based on: the inflation outlook, risks surrounding inflation, incoming economic and financial data and the strength of monetary policy transmission.

As President Lagarde stated clearly:

“We are not pre-committing to a particular rate path.”

Sources:

• ECB Monetary Policy Statement – Press Conference (4 February 2026)

• ECB Press Release – Monetary Policy Decisions

For Europe, this matters more than many people realise. Europe depends on open trade, a stable energy supply, and cooperation between countries. When the world becomes more divided, Europe feels the impact quickly - through prices, jobs, and financial markets.

Major institutions like the European Central Bank (ECB), the International Monetary Fund (IMF), and the Bank for International Settlements (BIS) now warn that geopolitical risk is no longer rare. It is becoming a lasting feature of the global economy.

A more divided world creates more uncertainty

The IMF describes today’s environment as one of global fragmentation — where countries cooperate less, and trade, technology, and energy decisions are reshaped by politics and security concerns. In Europe, this affects trade relationships, supply chains, energy prices and long-term investment decisions.

How geopolitical instability affects Europe

1. Trade becomes less reliable

Europe is one of the world’s largest exporters. Trade wars, sanctions, and sudden policy changes can reduce demand for European goods.

The European Commission has highlighted weaker external demand and trade uncertainty as key risks to Europe’s growth outlook.

This makes Europe more sensitive to developments in the US, China, and other major economies.

2. Energy shocks can return quickly

Geopolitical tensions often hit energy markets first. Even after diversifying supply, Europe remains exposed to global energy price swings.

The ECB warns that energy volatility can:

• raise living costs

• push inflation higher

• and weaken household purchasing power

Have a look at the ECB – Financial Stability Review.

3. Financial conditions can tighten fast

Geopolitical shocks can make investors more cautious. This can lead to: lower stock market valuations, higher borrowing costs, slower bank lending.

A joint ECB/European Systemic Risk Board report shows that rising geopolitical risks and policy uncertainty tend to be associated with tighter financial conditions and reduced loan growth.

This matters because Europe’s economy relies heavily on bank lending and credit flows.

4. Defense and security become economic priorities

As global tensions rise, European governments are increasing defense and security spending.

Defense investment supports specific industries and reflects a shift toward security and resilience over pure efficiency.

If you are interested in European defense stocks, you can find more information on this article: https://mrinvest.io/why-european-defense-stocks-are-a-smart-pick-for-investors-in-2026

What this means for Europe and investors

As an investor, you should know that geopolitical instability now directly affects Europe’s growth, inflation, and markets. Understanding this, helps you look beyond headlines and focus on long-term indicators, policy choices and investment trends.

Check out our other articles!
- Morgan Stanley's Outlook on the European Stock Market for 2026
- S&P Global Reveals Europe Economic Outlook for Q1 2026
- How the ECB thinks about inflation and interest rates

The big spark came from recent events in Venezuela. On January 3, 2026, U.S. forces carried out a military operation, capturing Venezuelan President Nicolás Maduro and his wife. This unexpected development, known as "Operation Absolute Resolve," has raised concerns about worldwide stability and increased focus on defense needs. In response, European defense stocks surged, with the STOXX Europe Aerospace & Defense Index climbing to its highest levels in months.

What's Behind the Growing Interest in European Defense Companies?

Geopolitical surprises, like the Venezuela situation, often lead to more spending on defense worldwide. European firms are in a good position to benefit because they supply equipment not just to their own governments but also to allies.

Adding to this, the European Union is stepping up its support. The European Investment Bank (EIB) has announced plans to increase lending for defense projects to €4.5 billion in 2026, up from €3.5 billion in 2025. This is part of a larger €100 billion lending program for the year (Reuters; EIB Official). The funds will help with areas such as military transport, border protection, and advanced anti-drone systems.

The European Defence Fund is also contributing, with around €1 billion allocated for research and development in 2026 to encourage innovation among companies (European Commission).

These initiatives show a clear commitment from EU leaders to build a stronger, more independent defense industry. For investors, this kind of long-term government backing can mean more reliable growth opportunities.

If you're interested in how central bank policies tie into broader market stability, you might enjoy our recent breakdown: ECB's Inflation Deviation and Monetary Policy Speech: A Simple Breakdown.

Some Leading European Defense Companies Worth Watching

Several established companies across Europe have seen strong gains recently and could continue to perform well:

• Rheinmetall (Germany): A major producer of armoured vehicles and ammunition, it's benefiting from Europe's focus on rebuilding ground forces.

• BAE Systems (UK): Known for aircraft, cybersecurity, and naval systems, with close ties to international partnerships. Its shares jumped nearly 5% following the Venezuela news.

• Leonardo (Italy): Specialises in helicopters, electronics, and aerospace, well-aligned with EU-funded initiatives.

• SAAB (Sweden): Excels in fighter jets, radar, and surveillance technology, appealing for its focus on innovation.

The overall sector had an impressive 2025, with the STOXX Europe Aerospace & Defense Index gaining over 65% last year, and it's carrying that momentum into 2026 (Datasite Insights; Defense News).

To see how this fits with positive views on European markets, check out Morgan Stanley's Outlook on the European Stock Market for 2026.

Looking Ahead to the Rest of 2026: Opportunities and Cautions

If global tensions remain elevated, defense spending is likely to stay high, supporting steady growth for these companies. Analysts see potential for solid returns, backed by multi-year contracts and EU funding.

However, there are always risks. If some international situations calm down quickly, demand could soften, leading to slower growth in the sector. Economic factors, like interest rates or broader market changes, could also play a role.

For European investors, this sector offers a way to diversify, especially alongside more traditional areas. It ties into themes of resilience and strategic independence that are key priorities here.

Overall, European defense stocks appear to be a thoughtful addition for many portfolios in 2026, blending real-world relevance with institutional support. As with any investment, it's essential to do your own research and speak with a financial advisor.

Stay updated on European economic trends with articles like S&P Global Reveals Europe Economic Outlook for Q1 2026 and Key Takeaways from the ECB's Last 2025 Financial Stability Assessment on mrinvest.io.

A brief lookback at 2025

In the first half of the year, Europe’s growth surprised many investors:

• Ahead of “Liberation Day”, tariff fears pushed investors to reduce U.S. exposure and diversify into Europe.

• Talks and headlines around Russia–Ukraine negotiations led to several investment themes emerging in European equities.

In the second half, Europe continued to perform, but less strongly than the U.S.:

• Around March, optimism peaked. Markets were very focused on Germany’s fiscal plans, but execution turned out to be slower than expected.

• Earnings growth weakened significantly across Europe, with expectations downgrading through the year.

The 3 key points looking into 2026

Looking into 2026, Morgan Stanley’s Chief European Equity Strategist Marina Zavolock highlights three main points.

The direction of US really matters for European stock markets

The first one is that Morgan Stanley’s Chief Investment Officer Mike Wilson remains very bullish on U.S. equities. In that scenario, Europe would benefit from the “slipstream” created by a strong U.S. market. Simply put, if U.S. equities are up strongly, it becomes very hard for European markets to fall.

However, Morgan Stanley is much more cautious on European earnings. While consensus expects very strong earnings growth in 2026 (13%), their forecast is much lower (just below 4%). This means that any upside in Europe would likely come more from valuations improving, rather than from earnings growth.

Different investment themes - thematically driven market

Earnings growth expectations in Europe are very high. Consensus is pricing in strong growth, which creates the risk of disappointment.

High earnings growth consensus, and rising competition from China

Increasing competition from China and Europe’s old economy exposure (this meaning traditional and often slower-growth sectors such as energy, materials, utilities, banks and telecoms) could drive most disappointment thematically.
“Sectors like chemicals, like autos, those are some of the sectors towards the bottom of our model. Luxury as well,” highlights Zavolock.

Pace of execution of Germany’s fiscal plan

There are two sides to the German fiscal policy:

1. Germany has a €500 billion infrastructure fund, but economists expect more of that money to be redirected towards social spending. That is less supportive for corporate earnings, and execution has so far been slow.

2. Defence spending, however is a different story. Execution is improving, the need is large, and Morgan Stanley remains extremely very bullish on the sector, mentioning that “the need is immense”.

AI exposure and utilities

This is the real bull case in Europe. If returns on investment start to “become material enough that it is hard to ignore” (likely H2 2026), Europe could benefit more than many expect.

The utilities “pocket” carries a lot of strength, helped by raising power demand, linked to increasing AI adoption.

Sector preferences

Banks

Banks clearly stand out in Morgan Stanley’s view, aligning with the S&P Global outlook for Q1 2026. A theme in Europe outside of Germany is fiscal constraints, which highly benefits the banking sector as banks are positively exposed to the steepness of the yield curve.

Defense

As we previously saw, defense is one of Morgan Stanley’s preferred sectors for 2026, as they start to see execution start to pick up now.

Utilities

As Zavolock mentions, “utilities have broken out of their downtrend in terms of valuation versus their U.S. peers. But still trade at very wide discounts […] Now that there is endless demand for power on the back of powering AI, investors are willing to benefit the sector.”

A very comprehensive overview on the outlook for European equities for 2026. Looking forward to see how it all plays out.

Source: Morgan Stanley - Thoughts on the Market: The Outlook for European Stocks in 2026

Overall, analysts expect GDP growth across European countries to continue at a similar pace in 2026 as in 2025. However, the growth distribution will change. One of the big players, Spain, which was a major contributor to the Eurozone growth, is expected to slow down. Germany, however, is expected to pick up after being a major contributor to the Eurozone's slower growth this year.

Germany’s expected growth

To understand Germany's expected growth, it helps to look at the background.

During Angela Merkel's time, Germany introduced the so-called "debt brake" (Schuldenbremse). This was a constitutional rule introduced in 2009 that limited federal borrowing to 0.35% of GDP to enforce fiscal discipline.

Following the 2025 German federal election and during the negotiations for the next cabinet, Friedrich Merz and Olaf Scholz reached an agreement on reforming the debt brake. They exempted defense spending above 1% of GDP and created a special fund of €500 billion for infrastructure.

Why is this important? This is the largest fiscal package since reunification 35 years ago. It is said to come from rising geopolitical tensions, pressure from the U.S. for Germany to meet NATO defense spending targets, and global competition challenging the German economic model.

The plan involves over €1.1 trillion in state spending over 12 years, which is about 25% of Germany's current GDP! The main goal is to allocate money to transport and digital infrastructure (roads, railways, and internet networks), defense, and the green transition (with around €100 billion for lowering energy costs and supporting electric vehicles). There are also tax changes starting gradually from 2028 (such as lower corporate taxes, faster write-offs for business investments, and relief on VAT and electricity taxes), labor incentives (like tax-free overtime, benefits for pensioners who keep working or for part-time workers, and a higher minimum wage), and deregulation (simpler rules for government contracts, faster project approvals, and switching to a lighter EU supply chain law). This stimulus is expected to boost German real GDP by an extra 0.5% in 2026, 0.7% in 2027, and 0.8% in 2028.

Germany's export model has faced difficulties for three years, with high energy costs, competition, and low public investment. Many manufacturing jobs have been lost.

Spillover effects from this big reform could add about 0.2% to Eurozone GDP over three years, with bigger benefits for Central and Eastern European countries!

Rate cuts?

Inflation has moderated in most of the EU, as a result of lower energy commodity prices, currency appreciation and loosening labor markets (ratio of vacancies to unemployment).

The S&P is clear about this, determining that adding up the assumptions for stable growth in 2026 together with inflation edging up again, the scope for monetary policy rate cuts across Europe is limited.

The outlook is more like: the ECB and the SNB (Switzerland) could start rising rates again in 2027 if GDP surpasses the potential. German stimulus and a tight labour market would support this.

Digital Transformation

Digital transformation is set to be one of the biggest growth factors across the EU. Gains have been clear in the European IT sector, with an annual growth of 2% since 2023. There is expectation for more investment in AI infrastructure in 2026, with EU policies supporting digital transformation at small scales.

Takeaways

Many unknowns remain, as this is a forecast. Risks to growth are numerous (tariffs, trade volatility, geopolitical tensions). Potential spillovers effects from slower growth from Europe’s main trading partners (U.S. and China). Rise in unemployment if labor costs reduce profit for companies. Tighter fiscal policy if consolidation intensifies.

Growth could also increase more than expected. German stimulus could have a bigger impact than assumed, easing inflation. Slowing geopolitical tensions could bring consumer confidence up, leading to higher spending.

Inflation could also be lower, if the appreciation of the Euro and the Swiss Franc continues and if the global competition for manufacturing intensifies. But it could be lower, if the economy accelerates more than anticipated.

Very excited to see how this all unfolds!

Source: Economic Research: Economic Outlook Europe Q1 2026: Germany’s Fiscal Reawakening

The ECB’s three-bucket scenario

1. Small and short-lived deviations → No action.
   Temporary noise is generally ignored. Policy takes time to act, so overreacting would create unnecessary volatility.

2. Large and persistent deviations → Clear action.
   If inflation threatens to settle materially above or below 2% for 1–2 years, expectations could become unsettling. In this case, the ECB would raise or cut aggressively as a prevention.

3. Medium-sized deviations → It depends entirely on the cause.

   • If it is demand-driven → Taylor Rule response - raise/cut rates.

   • Supply-driven (energy, food, global shocks) → Usually “look through” unless second-round effects appear in wages or profit margins. Why? Energy is only ~10% of HICP and these shocks tend to self-correct via terms-of-trade or demand responses.

Key quote from Lane:

“The appropriate monetary policy response to a deviation of inflation from the target is context-specific and depends on the origin, magnitude and persistence of the deviation.”

Current Context (December 2025)

• Headline CPI has been fluctuating between 1.8% and 2.4% in the fall, mainly due to base effects and energy prices.

• Core inflation and wage indicators are stable, around 2.1% to 2.3%.

• Inflation expectations are between 2.05% and 2.10%.

→ We are clearly in categories 1 and 3 (supply noise). The ECB is clearly saying: “don’t expect us to react to every headline figure.”

The Clear Winner - investment opportunity

In last weeks article, we already mentioned that the banking sector remains resilient. The best investment scenario from the analysis is focusing on European banks. With higher rates expected for a longer period without disruptions, this leads to a steepening yield curve and strong net interest margins. Eurozone banks are still trading at a lower book value compared to U.S. banks, making them an attractive investment. Top picks include BNP Paribas, ING, Santander, and UniCredit.

Key takeaway

Lane just handed markets a “don’t panic” note on headline inflation → stay long euro duration, stay very long European banks and cyclicals, and avoid overpaying for inflation hedges!

See you next week,
MrInvest

Source: https://www.ecb.europa.eu/press/key/date/2025/html/ecb.sp251203~0aa6ff1366.en.html

What the ECB is worried about

The ECB has been clear: financial stability vulnerabilities remain elevated, given uncertainty over geoeconomic trends and tariff impacts.

Trade policy shocks from earlier in the year (April 2025 US tariff announcements) have lessened due to US-EU agreements, but they could resurface, affecting euro area exporters.

Extremely high valuations of certain assets pose the risk of sudden adjustments, especially with the focus on US technology and AI-related companies. Global stocks are at record highs, but with the "Magnificent 7" accounting for about 30% of the S&P 500's market cap, any performance or earnings disappointment could trigger global risks, affecting the euro area. General exposure to US "spillovers" remains a major concern.

Moreover, a challenging fiscal outlook in some advanced economies could lead to stress in sovereign bond markets, upon testing investor confidence.

Increased defense spending could raise government debt and deficits for countries like Italy and Greece, which already have high debt levels. This could reduce their ability to respond to potential risks in economic growth.

The Good News

The Euro area banking sector remains resilient, maintaining high capital and liquidity buffers.

Return on equity averaged near 10% in the first half of 2025, driven by non-interest income and ECB rate cuts easing deposit costs.

Assets such as Barclays, Banco Santander and HSBC have been roaring over the past year, benefiting from this broader sector strength and global risk-on flows, even as euro area banks hold ample excess reserves above pre-pandemic levels.

See you next week,
Mr.Invest

Source: ECB Financial Stability Review – November 2025