Euro Volatility and Europe’s Growth Prospects: What Investors Need to Know

European Stocks Facing Tariff Chaos

So much for expectations that European stocks could avoid tariff chaos. One thing is certain: markets are in for a turbulent year, and even central bank support may not be enough to smooth things over.
Fear, uncertainty, and doubt lurk behind the apparent bull market. The DeepSeek episode turned out to be just the first warning sign for the return of volatility. Now that tariffs are in place, the euro is taking a hit, and investors are seeking hedging strategies while avoiding anything that appears vulnerable to U.S. trade policies. The deal to delay tariffs for Mexico and Canada offers some relief, but China has already started retaliating.

Deutsche Bank strategists, including Maximilian Uhler and Caroline Raab, have downgraded the European retail and staples sectors to neutral, as they are the most directly affected by the tariffs. The automotive and industrial sectors will also suffer, but to the same extent as their American counterparts, they note. Service sector companies will only feel an indirect impact if tariffs slow down economic growth.

European Central Bank (ECB) officials’ statements on Monday somewhat alleviated pressure, with the Stoxx 600 index bouncing off its lows, driven by optimism for more generous easing policies. However, this support will depend on the inflation trajectory, which is likely to weaken the euro even further, especially if the interest rate gap between the ECB and the Fed increases.

Inflation in Europe is already a concern, and tariffs will not help, potentially limiting the ECB’s ability to act. “Despite market expectations for inflation to decrease, January data actually showed an increase to 2.5%,” says Michael Field, Chief Strategist for EMEA at Morningstar. For stock markets, already rattled by tariff uncertainty, this negative data “adds fuel to the fire and will likely raise questions about the pace of interest rate cuts in Europe in 2025,” he adds.

Of course, a weaker euro may turn out to be positive for European earnings in the long term, as around two-thirds of Euro Stoxx 50 companies’ revenues come from outside the eurozone. In the short term, however, the currency acts as an indicator of market sentiment toward the region. Except for short periods of negative correlation, stock markets generally follow the movement of the currency, and a rising dollar is often a signal of increased risk aversion.

JPMorgan strategists, led by Mislav Matejka, view the level of the dollar as a “risk factor” for markets. Excessive dollar strength could become problematic for risk assets in general, while the weakening of the euro will affect sentiment in Europe. “The decline of the euro is seen by some as positive for European earnings,” they say. “From a mechanical impact standpoint, it certainly helps, but in reality, it doesn’t lead to sustained growth. Still, we believe most investors would be more concerned if, by mid-year, the euro were at 0.9 against the dollar than if it were at 1.15.”

Another problem facing Europe is positive positioning in stocks. This has risen dramatically in recent weeks, especially among systematic strategies like CTAs. Greater volatility and uncertainty could trigger profit-taking. These trend-following funds have aggressively bought European stocks, with exposure reaching the 80th percentile last week, touching levels last seen in May 2024 and April 2023. A period of consolidation followed. Hedge fund flows have also been directed toward Europe lately, according to JPMorgan Intelligence.