Even before US President Donald Trump sent global stock markets into turmoil with his tariff announcements, US stocks were heavily underperforming European equities, reversing a multiyear trend.
In the first quarter of the year, the Morningstar Europe Index gained 6%, while the Morningstar US Market Index lost 8.5% (in euros). The gap then continued to widen, with the European market up by almost 11% year to date and the US benchmark down 8.9% in the same period.
This is Europe’s strongest relative start to a year since 2000 and a marked contrast to its lackluster past decade. Even though skeptics might dismiss European stocks’ recent gains as little more than investors rebalancing portfolios toward cheaper areas of the market, more global investors believe that European equities offer opportunities, according to the latest JP Morgan Investment Strategy Report.
The Hunt for Value in Europe
“Much of the redistribution of capital from the US to Europe since the beginning of the year has been based on valuation, but more recently it is sentiment driven,” says Michael Field, Morningstar’s chief European market strategist.
“With investors shaken by the actions of the US administration and concerned about their ability to stifle equity market appreciation there, this could be possibly the start of the medium-term trend. But as valuations continue to adjust, the US could be seen in a more favorable light,” he adds.
Beyond the Trade War: Valuations, Earnings, and Defense Spending
Overall, the outlook for European corporate health has improved: companies in the Stoxx Europe 600 are expected to report a rise of 2.3% in first quarter earnings, on average, beating expectations, according to London Stock Exchange data.
Raheel Siddiqui, senior global equity research analyst at Neuberger Berman, expects Europe’s annualized profit growth to outpace the US for the first time in over a decade.
“Expansionary policies, including infrastructure spending and supportive monetary conditions, renewed focus on industrial growth and stronger corporate balance sheets should support investor optimism about Europe’s medium-term prospects. If these factors remain in place, Europe may continue narrowing the performance gap instead of merely enjoying a momentary upswing,” he says.
According to Michele Morganti, senior equity strategist at Generali Asset Management, “the US exceptionalism appears to be peaking,” while “monetary and fiscal policy looks increasingly supportive for the EU.”
European defense spending is expected to increase in the coming years, with the European Commission anticipating that defense investment could reach EUR 800 billion over the next four years. And with Germany presenting a fiscal stimulus worth EUR 500 billion over the next 12 years, that can “further amplify corporate profitability by modernizing key industries and spurring innovation,” says Neuberger Berman’s Siddiqui.
In addition, valuations still remain attractive.
“Based on the CAPE (cyclically adjusted price/earnings ratio), the S&P 500 is trading at a premium of 30% compared with its historical average, while Europe is trading at a more limited 10% premium,” says Generali’s Morganti.
Europe’s higher industrial exposure significantly influences its equity performance, making it particularly sensitive to global goods demand.
“Strong trade volumes can thus boost European valuations, positioning the region to outperform if international commerce remains healthy,” says Neuberger Berman’s Siddiqui.
European Earnings Expectations Drift
Robert Griffiths, global equity strategist at L&G, is more wary. “We would be a little bit skeptical of the enthusiasm toward Europe which has built this year,” he says.
“A combination of euro strength and some weakness in end markets has seen European earnings expectations actually drift lower this year, even as optimism has moved higher. We shouldn’t forget that US outperformance was really underpinned over the last decade by earnings delivery. Europe is now in the unusual position of needing to deliver on expectations which, for once, are not on the floor.”
Griffiths says that a lot rests on the shoulders of the new German government: “Any signals of disunity of volatility in the governing coalition could be particularly problematic for the enthusiasm which has built around European assets.”
Buybacks Add Fuel to Europe’s Rally, But for How Long?
One of the key differences between the European and the US equity markets is that US stocks historically benefited from extensive buybacks that boosted earnings per share as well as investor confidence, underpinned by a perception that global capital had nowhere else to go. On the other hand, companies in Europe have traditionally preferred dividends over stock repurchases as a way to hand cash back to shareholders.
This could change: in April, companies in the Stoxx Europe 600 index bought back EUR 17 billion worth of shares, an all-time record.
Will this trend continue, and will it be enough for European stocks to replace their US peers as a “must have” in investors’ portfolios?
“There were several drivers of the US market rally over the last decade or so,” says Morningstar’s Field.
“The development and growth of the Magnificent Seven played a big part, and more recently the Inflation Reduction Act had a large impact. Recent actions by the US administration have done much to convince investors that they cannot put all their eggs in the US basket, which bodes well for Europe. While European growth still lags that of the US, the gap is closing, and Europe still has a lot of dry powder.”
At the same time, according to Neuberger Berman’s Siddiqui, simplified supply chains, targeted industrial policies, and stronger domestic consumption could further enhance shareholder value, even without mimicking the American buyback model.
Still, he says that Europe’s ability to replicate US-style returns remains uncertain: “Structural concerns around innovation gaps and complex regulatory frameworks endure. But with improved lending conditions and fresh infrastructure spending, we are optimistic that Europe can produce meaningful gains for investors if reforms persist. Overcoming entrenched inefficiencies remains critical for long-term convergence prospects.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
