Following another strong year of “U.S. exceptionalism” in economic growth and market returns, non-U.S. equity markets are leading this year. U.S. equities are up 4.6%, while international equities excluding the U.S. are up 7.1%, driven by multiple expansion, and some improvement in earnings expectations and currency appreciation. Leading are the equity markets that had underperformed last year: LATAM, China, Korea and the Eurozone (all up over 10%). European performance stands out, with the best start since 1997. Is this strong performance sustainable? After the initial rerating, much will depend on the sustainability of the cyclical recovery – and importantly on whether more structural changes are afoot. 

Entering 2025, European equity valuations were average historically but heavily discounted versus the U.S. at 41% (versus the average 16%), with every sector discounted except technology¹. This year’s rerating spans multiple sectors, notably health care, communication services, industrials, financials and consumer discretionary. The catalysts for this re-rating have included cyclical and structural factors:

Greenshoots in the cyclical data:

1. Cautious consumers starting to perk up: Euroarea consumer confidence has moved up for two months, a glimmer of hope that the record-high excess savings cash pile is finally set to be spent. A resolution to the War in Ukraine could serve as another positive confidence shock.
2. Manufacturing sector awakening from its slumber: The Composite Euroarea PMI survey has moved up 2 points since the November low, led by manufacturing. A resolution to the War in Ukraine could provide the return of cheap Russian gas through the Ukraine pipeline.
3. Financial conditions have started to improve: Bank lending to households and corporates picking up in December. Importantly, the ECB may still have scope to cut rates another 75bps this year – all important for a real economy dependent on floating rate bank loans.

More steps in the right direction to tackle structural issues:

1. Potential removal of the German debt brake: Unlike the U.S., Germany has remained focused on strict budget discipline², despite a weak manufacturing sector. Momentum seems to be finally turning towards more fiscal spending, culminating in this year’s German Elections.
2. More tolerance of fiscal spending, especially on defense: Over the last decade, some European countries like France and Germany have raised defense spending to NATO’s 2% of GDP goal, but more indebted countries have not. European Commission President Ursula Von der Leyen has suggested increasing the goal to 3% of GDP. A bigger game changer would be using a Euroarea common financing mechanism to fund regional defense spending³.
3. A moment for unity in response to U.S. tariffs? The likelihood of the U.S. imposing retaliatory tariffs on European imports, especially autos, seems high. Typically, a “crisis” prompts European countries to unite to address common issues. This may be an opportunity to enact productivity-enhancing reforms, like removing barriers to trade within Europe and reducing regulations in the digital/technology sector.

Whether the rerating continues depends on more improvement in the cyclical data (U.S. retaliatory tariffs on European goods are an important risk) and, importantly, on substantial improvement on the structural issues. Doubts on the latter removes conviction on an overweight to European equities now; nevertheless, this episode is a reminder of the importance of valuations when investing and of maintaining sufficient global equity exposure.

¹ The technology sector within the MSCI European Monetary Union represents 13% of the index, with two companies dominating (SAP and ASML). On their own, these two companies represent 10% of the overall index.

² The German constitutional debt brake stipulates that the federal government can have a structural deficit of no more than 0.35% of GDP per year.

³ A white paper on defense spending is set to be published by the European Commission on March 19th. 

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