Investor sentiment toward Europe has noticeably improved, driven by falling inflation, interest rate cuts, and a rebound in real incomes. However, it may be premature to become complacent. Many economists warn that the European economy still faces significant challenges ahead.

Currency strategists at Capital Economics caution that optimism may be masking deep structural issues that will shape the continent’s trajectory. On May 19, the firm published a report titled "The Future of Europe," highlighting three core questions confronting the region.

The first question revolves around whether other European nations can follow Germany's lead in pivoting toward looser fiscal policy. "Trying to do so could precipitate national fiscal crises," the report notes. Capital Economics remains skeptical, particularly with regard to debt-burdened countries like France and Italy.

The second question is whether Europe can keep up with innovation. The region is under mounting pressure to implement structural reforms. Its lag in artificial intelligence and other cutting-edge technologies is becoming increasingly apparent. Without sweeping reforms, analysts believe that Europe "risks remaining stuck behind the technological frontier." Rising competition from Chinese firms only intensifies this pressure.

The third issue concerns Europe's role in a shifting global power structure. Amid escalating tensions between the United States and China, Europe aims to maintain its position as a "third pole." However, Capital Economics highlights internal divisions within the euro area. "The European project isn't hard-wired to project power – hard or soft – to the extent that the US and Chinese governments are," the report argues.

Against this backdrop, the euro does not "present a meaningful challenge" to the dollar's dominance. According to strategists, competing with the greenback remains a distant goal.

Although the ECB's policy tools have been effective in reducing systemic risk, the outlook for the European economy remains fragile. The report notes that Europe is unlikely to match US growth in the near term due to its dependence on energy imports and structural weaknesses in its labor market.

In the long run, Capital Economics expects Europe to remain a "wealthy but relatively slow-growing region," trailing in innovation but still offering attractive investment opportunities.