Europe’s stock markets are finally having their moment in the sun

When we reach the half-way point of 2025 it will be surprising if the regional equity market leaderboard is not topped by Europe. With a few days to go to the end of June, the Euro Stoxx index is up 20% in the year to date, twice as much as its closest rivals - emerging markets and the UK. The US - both the S&P 500 and Nasdaq - are marginally under water, despite a spectacular V-shaped recovery from the ‘liberation day’ slump. It is Europe’s strongest relative start since 2000.

This was not what investors expected. Six months ago, US exceptionalism was alive and kicking and the European glass half empty. Capital had flowed west for years as America accelerated out of the pandemic, buoyed by Biden-era fiscal spending. Europe, meanwhile, had flirted with recession in the wake of Russia’s invasion of Ukraine and the energy-fuelled inflation it triggered.

Even after half a year of steady outperformance, in up markets and down, many investors are still struggling with the new reality. We have had a few months of inflows to European equity markets, but this has barely made a dent in an extended period of outflows. When the market pendulum swings, it tends to be a multi-year reversal. No-one should fear that they have missed the boat.

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The first three months of 2025 was the first quarter of positive flows into European equity funds after 12 consecutive quarters of net outflows. The €26bn taken in has almost been matched by €22bn in April and May and the second quarter is, therefore, shaping up to exceed the previous record of €31bn, achieved in 2015 as the region emerged from the eurozone sovereign debt crisis.

So, what has got investors so excited? The first point to make is that investment is a kind of zero-sum game. For money to flow into one market, it must flow out of another. And Europe’s biggest advantage today is that it is not America. As I pointed out a couple of weeks back, there are good reasons to maintain an exposure to the world’s biggest stock market - demographics, energy security, easier regulation, and a huge domestic economy among them. But in the short run, policy uncertainty, recession risk, an inflationary trade war and punchy valuations make a rotation out of US assets an uncontroversial trade.

There is plenty not to like about European politics. It is cumbersome, bureaucratic, over-keen on regulation and fragmented. It does not encourage innovation. It is more stakeholder than shareholder friendly. But it is predictable. It does not change its mind every five minutes. And that gets a tick from investors who, as a rule, dislike surprises.

One of the advantages of Europe’s political stability has been that the European Central Bank (ECB) has been able to anticipate continuing disinflation and cut interest rates accordingly, unlike the Fed which has been forced to sit on its hands to see whether on-off tariffs will be inflationary or recessionary. The President may call Jerome Powell ‘Too Late’, but there is a reason why the Fed chair is not rushing to claim victory over inflation.

The ECB has halved its interest rate to 2%, and monetary policy will contribute to the region’s growth outlook this year and next. So, too, will fiscal policy, with the International Monetary Fund estimating that a looser tax framework will deliver a 1.6 percentage point stimulus in Germany and 0.8% in France.

At the heart of this is a blueprint to improve Europe’s military readiness through higher defence spending. Member states will be able to deviate from the EU’s fiscal rules to buy tanks, guns and military tech. Germany alone is planning to spend an additional €500bn. After years in which the engine of European growth sputtered along in second gear, there is the prospect of a multi-year period of turbo-charged military-industrial investment. America’s reluctance to backstop European defence has been a gift.
There is a question mark over the speed and extent to which this feeds through into growth. There is further doubt as to which companies will ultimately benefit from the increased spending. There is many a slip twixt cup and mouth, and the soaraway share prices of businesses like Rheinmetall may well come back to bite investors who have tried to get ahead of the curve.

But earnings follow economic growth and, at the margin, analysts’ forecasts for European companies are nudging higher at the same time as those for their US counterparts are in decline. Earnings expectations are important because, for years, the US’s valuation premium has been justified by the greater profitability of US companies. If US and European valuations are to move closer, it will only be on the back of a narrowing earnings gap.

Another important advantage that Europe has over the US is the greater income it offers investors. A dividend yield of more than 3% is twice that paid by US companies, and more European companies pay a dividend at all (93% versus 75%). Goldman Sachs expects European companies to return 5% of their value to shareholders through dividends and share buybacks this year versus 4% for US companies.

Of course, there are risks with a shift away from the US towards Europe. A weakening dollar will reduce the value on translation of the quarter or so of European company profits that is earned in America. Trade uncertainty remains significant as we approach the end of the 90-day tariff pause. But after years in which investment portfolios have become over reliant on the US, there is scope for at least some of that money to find its way back home.

This article originally appeared in The Telegraph.

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