Eurozone Stagnation: A Structural Shift to Moderate, Uneven Growth

The eurozone economy ended 2025 on a note of stability, but the momentum for a robust recovery has clearly stalled. While the bloc recorded its strongest quarterly growth in over two years, the pace of expansion slowed significantly in December, revealing a fragile equilibrium. This is not a return to stagnation, but a structural shift to moderate, uneven growth.

The primary driver of this expansion remains the services sector, which continues to grow but is cooling. The services business activity index eased to 52.4 in December, down from a two-and-a-half-year high. More critically, growth is becoming increasingly reliant on domestic demand, as export-oriented services weakened notably. This shift reduces the sector's external resilience and points to a more inward-looking engine of growth.

At the same time, manufacturing activity contracted for the first time in eight months, acting as a persistent drag. Factory output fell marginally, and new foreign business contracted sharply. This weakness in the export channel is a key vulnerability, especially as the bloc faces ongoing trade headwinds. The broader private sector output index slipped to 51.5 in December, its weakest rate since September, underscoring the uneven nature of the expansion.

The result is a fragile balance. Solid services momentum has so far offset manufacturing weakness, allowing the eurozone to expand every month in 2025 for the first time since 2019. Yet the data shows a loss of speed rather than a renewed downturn. This new normal is defined by a services sector that is cooling and domestically focused, weighed down by a manufacturing sector that remains weak and export-dependent. The path forward, as one economist noted, is likely to be a moderate growth path with limited upside, where the stability of services is constantly tested by the fragility of industry and trade.

Policy Inertia: The ECB's Neutral Stance Locks in Stagnation

The eurozone's new normal is being cemented by monetary policy. With inflation hitting the European Central Bank's 2% target in December and core prices easing, the bank is effectively on hold for the foreseeable future. This creates a structural policy environment that disincentivizes acceleration, locking in the moderate growth path.

The latest data shows the disinflationary trend is firming. Inflation slowed to 2.0% in December, meeting the ECB's target, while core inflation excluding food and energy eased to 2.3%. This aligns with the ECB's own updated projections, which see headline inflation averaging 1.9% in 2026, below target. The bank has signalled it will keep its 2% deposit rate steady through all of 2026, with market expectations for no cuts until at least the second half of the year.

This sets up a clear policy dilemma. On one side, inflation is falling and is expected to remain subdued. On the other, the ECB's growth forecasts have been revised up to 1.2% for 2026, driven by domestic demand. With inflation undershooting and growth only modestly accelerating, the bank has little incentive to cut rates. The neutral stance reinforces the current trajectory, providing no monetary tailwind to revive the weak manufacturing sector or boost exports.

The result is policy inertia that matches the economic stagnation. The ECB's "data-dependent" approach means it will wait for clearer signals of either persistent undershooting or a resurgence of underlying price pressures before acting. In the meantime, the steady 2% deposit rate acts as a floor, preventing a rush of cheap credit that could overheat the domestic economy. This deliberate neutrality ensures the eurozone's growth remains steady, but also ensures it remains moderate. The policy environment is now structured to maintain the status quo, not to break it.

Structural Drivers and Sectoral Divergence

The eurozone's growth model is now firmly anchored in domestic forces, but this pillar is showing signs of strain. The primary support comes from resilient labor markets, with employment continuing to expand and unemployment rates near historic lows. This stability, combined with supportive fiscal policy, especially in Germany, is underpinning consumer demand. The Mastercard report notes that lower inflation, declining interest rates, and resilient consumer demand will bolster the domestic economy in 2026. Yet, this demand is selective; consumers are prioritizing smaller indulgences over big-ticket items, a caution that limits its potency as a growth engine.

This reliance on internal demand masks a stark divergence across the bloc. Performance is highly uneven, with Southern Europe leading the way. In the third quarter, Spain remained the best performer, expanding 0.6%, while France grew 0.5%. In contrast, the two largest economies are struggling. Germany stagnated due to a decline in exports, and Italy stalled, with its industrial sector contracting. The Mastercard forecast highlights this split, projecting the strongest acceleration in Germany (from 0.3% in 2025 to 1.2% in 2026) and Southern Europe (2.1% in Spain). This creates a fragile balance where the overall 1.2% growth forecast for 2026 depends on weaker members catching up, a process that is far from guaranteed.

The external sector, the traditional growth driver, faces mounting headwinds that threaten to undermine the domestic model. While some easing of trade tensions has occurred, the impact of higher tariffs is expected to become more evident in 2026. The UN report warns that the impact of higher tariffs, coupled with elevated macroeconomic uncertainties, is expected to become more evident in 2026. This creates a direct pressure point for export-oriented industries, which have already shown weakness. The ECB's own projection notes that exports are expected to pick up next year, but this improvement hinges on a rebound in foreign demand amid declining trade policy uncertainty. The fragility of this setup is clear: a resurgence in global trade tensions could quickly reverse the modest export recovery and force the domestic demand pillar to bear the entire weight of growth, a role it may not be equipped to handle.

Catalysts and Risks: The Path to 2027

The eurozone's path to 2027 hinges on a single, unresolved question: when will manufacturing finally turn? The current stalemate is defined by a fragile services-led expansion and a persistent industrial drag. For growth to accelerate beyond its projected 1.2% for 2026, a sustained recovery in factory output is the primary catalyst. Yet, the latest data suggests this is still several quarters away. The HCOB Flash Eurozone Manufacturing PMI fell to 49.2 in December, its weakest level in eight months, with production declining and new foreign business contracting sharply. This points to a deep-seated weakness that is not easily reversed. A credible rebound would require a clear shift in the services PMI, which is currently cooling and becoming more domestically focused, and any signs of a sustained pickup in export-oriented manufacturing. Until then, the domestic demand pillar must carry the entire weight of growth, a role it may not be equipped to handle.

The broader global context presents a key risk that could reinforce the trend of moderate, uneven growth. The United Nations warns that subdued investment and limited fiscal space are weighing on economic activity, raising the prospect of a persistently slower global growth path. This creates a headwind for the eurozone's export sector, which has already shown weakness. The impact of higher tariffs, coupled with elevated macroeconomic uncertainties, is expected to become more evident in 2026. For the eurozone, this means the modest export recovery the ECB forecasts for next year is far from guaranteed. If global demand falters, it would force the domestic economy into an even more precarious position, potentially triggering a broader slowdown.

For investors, the forward view must be calibrated to these structural constraints. The key signals to watch are twofold. First, monitor the services PMI for any stabilization or reversal of its cooling trend, as this sector remains the bedrock of current expansion. Second, and more critically, watch for a sustained rebound in the manufacturing PMI, particularly in export-oriented segments. A move above 50 for several consecutive months would be the clearest early signal of renewed momentum. In the meantime, the setup is one of policy inertia and uneven domestic strength. The path to 2027 is likely to be a slow climb, where the fragile balance between cooling services and a weak industrial base is constantly tested by external pressures.