Europe won’t displace US economic power any time soon

Welcome back. Two themes are shaping market sentiment right now. First, Donald Trump’s policy agenda is compromising US economic, financial and institutional superiority. Second, relative stability and political developments are improving the outlook in Europe.

Reflecting this, in March, Bank of America’s fund manager survey showed the sharpest rotation out of US stocks and into European equities on record.

One theory now being floated as a result of these trends is whether America’s long-term economic growth advantage over the continent has also entered its twilight. For all my recent bearish US and bullish Europe analyses, I think this notion is overstated. Here’s why Europe will not take America’s economic mantle any time soon.

First, when it comes to underlying growth rates, the size of the US’s lead over Europe is significant.

Fitch Ratings has calculated that over the past 5 to 10 years, America’s potential supply side annual growth rate — factoring in capital, labour and technology — averaged around 2.5 per cent. For the Eurozone it has been closer to 1 per cent. That’s before assessing the impact of policy decisions on both sides of the Atlantic this year.

Trump’s agenda will crimp US productivity. Tariffs will create inefficiencies. Uncertainty will dent capital investment and research and development. A clampdown on immigration and a possible brain drain would also weaken labour supply.

Still, the damage caused by the president would need to be quite extraordinary to permanently erode America’s structural economic growth advantages over Europe, says Andrew Kenningham, chief Europe economist at Capital Economics:

“The US has a larger and more unified internal market for scaling, a stronger venture capital ecosystem, more world-class universities and lighter touch regulation.”

Indeed, in terms of total inputs, the EU has an advantage in workers, and the US has a lead in physical and financial capital. But America’s growth advantage largely emanates from its higher “total factor productivity”, or how productively its inputs are used.

In Europe, a growth boost from capital inflows is possible if investors see the continent as an alternative safe haven. But the effect may be limited, not least by investment opportunities.

“Whether the rotation into European assets can persist is questionable. Trump’s craziness can accelerate the dollar’s decline as a reserve currency, but the US’s vast capital markets and liquidity mean it will be slow,” says Kenningham.

So, can Trump do significant — and permanent — damage to this advantage in economic dynamism? That depends on how one expects the remainder of his second term to pan out.

There are checks on the administration. The president has already softened his most extreme tariff plans and attacks on the US Federal Reserve’s independence, amid rapidly rising long-term bond yields.

Broader political pressure will also increase. Year-ahead inflation and unemployment expectations have shot up. Republican consumer confidence, which tends to track approval ratings when Trump is in power, appears to be plateauing.

The impact of existing duties, particularly on China, will also soon filter through. “Price increases and shortages in stores will probably be felt from mid-June onwards,” says Paul Donovan, global chief economist for UBS global wealth management. “This will weaken sentiment among more Republican voters.”

In the coming 12 months, the market expectation is for the US effective tariff rate to ultimately land between a still painful 10 and 20 per cent — from well above 20 per cent now. Business activity will be stymied by ongoing uncertainty. Wall Street now sees a close to 50-50 chance of recession.

The Republican party has thin majorities in the House of Representatives and the Senate. “Often the midterms render a second-term president a lame duck. But with higher prices and unemployment likely to be felt by then, that vote may be particularly bad for the Republicans,” notes Matt Gertken, a chief strategist at BCA Research.

This does not preclude significant damage to the trajectory of US economic growth. Trump might lean on his executive powers even more. Political risk strategists highlight four main threats: undermining Fed independence, a Treasury market crash, capital controls, and somehow legalising a third term (which would enable sustained damage from policy).

These could each significantly impair the US economy, and sap its ability to channel inputs as productively over time.

But most experts reckon all of these — except threats to the Fed — are low probability events, given financial market, political and legal obstacles. And even if Trump replaces Fed chair Jay Powell with a more pliant central bank chief, Cedric Chehab, chief economist at BMI, notes that other Fed board members and the requisite approval of any new chair by Congress will limit the risk of a significant deviation in monetary policy approach.

In all, Capital Economics does not expect the US or Eurozone potential growth rates to change notably from Fitch’s historic estimates in the long run post-Trump.

This assumes tariffs settle at 10 per cent on the rest of the world and 60 per cent on China in his term, and that the president’s trade and immigration policies are eventually unwound after he leaves office. It also reflects greater benefits of artificial intelligence accruing to the US relative to Europe. (Deregulation efforts, such as leaner planning rules under Trump, would also be supportive.)

How likely is this? Given the trajectory of economic sentiment (and limits to offsetting the negative income effects of import duties with tax cuts, as I assessed in the April 6 edition), a non-Maga presidential election victory is likely in 2028 (though not guaranteed).

The past half century of survey data suggests party power tends to change hands when voters feel significantly worse off at the end of a president’s term than they did at the beginning. Barring a more notable tariff climbdown, that seems plausible under Trump.

In that case, much of his agenda could be unwound. Uncertainty would lift. Business investment would pick up. And capital would probably flow back to America.

Though import levies might be sticky, the economic price of a high tariff wall will probably undermine the policy case for duties over time (as analysed in the March 30 newsletter).

This does not mean the US economy will spring back to its original growth rate immediately after Trump. Permanent reputational damage is possible (particularly if Maga politics endures). Not all policies might be reversed. But the hit to the US’s underlying growth rate won’t be as strong as perhaps expected.

What about Europe’s ability to catch up? “Slow-moving structural factors — such as weak population growth — are difficult to overcome,” says Charles Seville, a senior director at Fitch Ratings. “This puts the onus on investment, productivity growth, and active labour market policies.”

Recent shifts in EU economic policy are genuine but should not be overstated. Germany’s defence and infrastructure stimulus will boost growth in the EU’s largest economy, but region-wide capital expenditure is also required. The bloc’s wider rearmament push could boost demand rather than lifting trend productivity growth, particularly if less is spent on cutting-edge tech.

Implementing Mario Draghi’s blueprint to raise European productivity — from expediting capital and fiscal union efforts to aligning red tape — will also face hurdles, notes Lorenzo Codogno, a former chief economist at the Italian Treasury department. “The reform process is incremental in normal times. Negotiating across 27 member states remains a battle.”

Europe’s near-term growth outlook is itself dented by Trump’s agenda, with the US exporting uncertainty and trade disruption. This risks sapping political bandwidth for reform efforts too.

All this suggests the continent won’t be able to make significant inroads on the US’s growth advantage, particularly by the time the president’s term ends.

So, factoring in America’s current economic lead, Trump’s ability to damage it and European reform efforts, it’s difficult to envisage the US’s growth advantage coming under threat from Europe in the medium term.

This may seem counterintuitive given the current newsflow. But recency bias is common when watching the markets. Obvious risks to my outlook include Trump’s unpredictability and the 2028 election.

Still, my baseline is for US economic exceptionalism to emerge from Trump 2.0 dented, maybe with permanent reputational damage as investors take a more diversified approach to safe havens and reserve currencies. The EU may look more promising. Nonetheless, the delta between America and Europe’s trend growth rates may be surprisingly little changed.

Where do your assumptions differ? Let me know: freelunch@ft.com or on X @tejparikh90.

Food for thought

How much should governments be spending to reduce existential threats from artificial intelligence? This paper does the maths.