Eurozone outlook darkens amid energy crunch

The eurozone is facing deepening economic woes from the conflict in the Middle East as surging energy prices choke growth. The bloc’s economy expanded by only 0.1% in the first quarter, while inflation rose to 3% in April, its highest level since September 2023.

The labor market has held up better. The unemployment rate fell to 6.2% in March, helped by modest hiring in Spain and Italy across tourism and services. But other indicators are softer. Manufacturing is expanding, though more slowly, while business confidence has weakened, particularly in services and construction.

At the start of the year, the European Commission forecast European Union (EU) GDP to grow 1.4% in 2026, with inflation rising little above 2%. But in May, it significantly changed those projections, with GDP increasing only 1.1% and inflation soaring to 3.1%, and also expecting the unemployment rate to rise.

A difficult policy trade-off

At its April meeting, the European Central Bank (ECB) kept its deposit rate unchanged at 2%, stressing that upside risks to inflation and downside risks to growth had both intensified. Markets have since pushed back expectations of near-term easing and, at the time of writing, were pricing in at least two rate increases in 2026, with a first 25 basis-point move possible as early as June.

In the bond markets, euro area spreads have remained stable, but the repricing of ECB expectations pushed the two-year German Bund yield to about 2.70% in mid-May, underlining how little room investors now see for near-term easing. The Italy-Germany 10-year spread has remained broadly steady at about 75-80 basis points, though Italian debt has come under slightly more pressure due to the country’s energy exposure and fiscal backdrop.

The near-term outlook still depends heavily on geopolitics. If the US and Iran move toward a resolution and the Strait of Hormuz reopens fully, the latest inflation spike may prove temporary, allowing the ECB to look through part of the shock. If not, and energy prices remain high, the drag on global growth will deepen, with Europe likely to be among the most exposed regions.