Despite the ongoing Iran conflict disrupting European energy markets, the eurozone economy has delivered a performance that has surpassed many forecasts. A recent analyst survey indicates that the growth forecast for the 21-nation eurozone for the full year 2026 has been significantly revised upward from 0.5% in July to 0.8%. This adjustment almost entirely reflects the unexpectedly strong second-quarter economic performance, where GDP grew by 0.4% quarter-on-quarter, double the 0.2% economists had predicted.
More surprisingly, this resilience was achieved amid multiple headwinds, including soaring energy prices triggered by the Iran conflict, widespread cost-cutting and layoffs by European automakers, raging wildfires, and historically low water levels in key waterways such as the Rhine and Danube rivers. The eurozone is demonstrating with data that its "immunity" to geopolitical shocks is far greater than the market had previously anticipated.
Second-Quarter "Surprise": AI Investment and Consumer Confidence as Dual Drivers
Data from Eurostat released on July 30 showed that the eurozone's second-quarter GDP grew by 0.4% quarter-on-quarter, with year-on-year growth accelerating to 1.0%, well above the market expectation of 0.5%. This marks one of the strongest quarterly growth rates for the eurozone since 2023. This outperformance was driven by three forces. First, the wave of AI investment: European companies are following the global trend by significantly increasing investment in intangible assets related to artificial intelligence. In its economic bulletin released on August 5, the European Central Bank specifically noted that corporate investment is shifting from tangible assets to intangibles like AI, stating that "this compositional shift may gradually act as a stabilizer for the investment cycle." The ECB estimates that uncertainty has dragged down eurozone economic growth by 0.4 percentage points between 2025 and 2026, but the resilience of AI investment is mitigating this drag. Second, consumer confidence has proven surprisingly robust: although consumer confidence in the eurozone plummeted after the outbreak of the Iran conflict, it has since recovered. Household consumption in the second quarter performed far better than gloomy predictions. Third, Germany's fiscal expansion has begun to take effect: the government led by Chancellor Friedrich Merz has agreed on a comprehensive reform package aimed at enhancing medium- to long-term economic potential. Germany, France, and Italy all achieved 0.2% quarter-on-quarter growth in the second quarter, with Spain continuing to lead the eurozone with 0.7% growth.
July PMI Confirms Recovery Momentum: Services Return to Expansion, Germany Exits the Trough
The strong momentum from the second quarter continued into July. The eurozone Composite Purchasing Managers' Index (PMI) from S&P Global, released on August 5, rose from 50.0 in June to 52.0, hitting an eight-month high and returning to expansion territory for the first time since March. Key details indicate the recovery is becoming more broad-based: the services PMI jumped to a five-month high of 51.7, expanding for the first time since March; Germany recorded its first private sector output growth since March; growth accelerated in Italy and Spain, with Spain posting its best performance in over a year and a half; employment stabilized in July, ending six consecutive months of layoffs; and business confidence rose to a five-month high. As business confidence recovered, input cost inflation fell to a five-month low, and output price inflation dropped to its lowest since March, providing the European Central Bank with some breathing room between controlling inflation and supporting growth. Capital Economics economist Andrew Kenningham stated, "Looking ahead, we believe the eurozone will continue to cope relatively well with the energy shock stemming from the Iran situation and expect quarterly GDP growth rates of around 0.25% over the next year or so." He added that if energy prices remain persistently high, the economy still faces downside risks, but these risks may be smaller than generally expected.
Germany: Defense Spending as an "Economic Stabilizer"
As the eurozone's largest economy, Germany's recovery outlook is particularly crucial. Another survey shows that a surge in German defense spending will help drive the overall economic growth rate from 0.8% this year to 1.2% by 2028, an upward revision from the 0.6% forecast last month. The government led by Chancellor Friedrich Merz has agreed on a comprehensive reform package aimed at enhancing medium- to long-term economic potential. The core of this package is a modification of the "debt brake" clause in the German constitution, exempting defense spending, which effectively allows Germany to borrow unlimited amounts for military purposes. According to the German Finance Ministry's plan, Germany will borrow over 800 billion euros by 2030, breaking decades of fiscal restraint. In the year 2027 alone, the government plans to raise over 200 billion euros from the market. The Bundesbank's analysis is more specific: government spending, especially on defense, is expected to cumulatively boost economic growth by 1.3 percentage points by 2028. The Bundesbank forecasts calendar-adjusted GDP growth of 0.5% for 2026, 0.8% for 2027, and 1.4% for 2028. The Ifo Institute maintains its 0.8% growth forecast for 2026 unchanged. However, the German economy still faces significant headwinds. Ifo warns that even if a preliminary ceasefire is reached between the US and Iran, energy prices are expected to remain high. The government's expansionary fiscal spending is expected to boost economic growth by 0.5 percentage points each in 2026 and 2027, but the drag from the energy price shock is estimated at 0.4 percentage points. Constrained by both an aging population and sluggish productivity growth, Ifo warns that Germany's potential growth rate could fall to just 0.1% by the end of the decade.
Risks Remain: Rhine River Low Water Levels and Inflation Rebound
Despite the improved growth outlook, the eurozone economy still faces multiple structural risks. The Rhine River shipping crisis is the most pressing supply chain threat. Known as "Europe's transport artery," the Rhine carries about 80% of Germany's inland waterway freight. Due to high temperatures and drought, current ship loading capacity is only about one-third of normal levels. The reduced cargo capacity has increased the number of port calls by ships by 50% to 60% in recent weeks. This month, the cost of transporting refined oil products from the German industrial city of Karlsruhe to seaports like Rotterdam in the Netherlands has reached 200 euros per ton, breaking the previous record of 130 euros per ton set in August 2022. On August 5, the water level at the crucial Kaub chokepoint on the Rhine broke the historic low set in 2018. The Rhine handles the majority of Germany's inland freight traffic, with numerous chemical, steel, refining, and energy companies located along its banks. The cost of shipping oil products from Rotterdam to Karlsruhe via inland tankers has surged from about 45 euros per ton at the end of June to between 150 and 160 euros per ton. The Kiel Institute for the World Economy estimates that low water levels could cost the German economy between 1 and 2 billion euros in the third quarter. British media noted that the low Rhine water levels are not only forcing some German manufacturers to cut production but could also affect the growth outlook for Germany and more European countries this year. German chemical company Covestro stated that restricted Rhine shipping has already affected supply and production at some of its plants. Nearly 75% of its production raw materials and over 30% of its finished chemical products are transported via the Rhine. Cologne-based chemical company Lanxess described the current situation as "very serious." ING economist Carsten Brzeski warned that the 2018 drought reduced German economic growth by about 0.3 percentage points, and the economic impact from this year's drought could be more severe. Inflationary pressures are also a concern. The eurozone's inflation rate in July rose to 2.9% from 2.8% in June. A Reuters survey expects the European Central Bank to raise its key deposit rate in September. The ongoing conflict in the Middle East also means energy prices could spike again. Germany's Ifo has revised its 2026 inflation forecast up to 2.9% and its 2027 forecast to 2.7%. The European Central Bank expects that uncertainty will continue to drag on economic activity for the remainder of the year.
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