Some would say the tides have turned in developed market equities. After years of U.S. outperformance, Europe has outperformed year-to-date (YTD), with a 23.9% total return (in USD terms) compared to a 7.8% performance by the S&P 500. However, investors are questioning whether Europe can maintain this outperformance. This article responds to the common questions regarding flows, sector performance, tariffs, and valuations.

A quick refresher: loosening of the reins

European underperformance has often been attributed to tight reins by policymakers across monetary, fiscal and regulatory aspects. These are now loosening, supporting growth in the short, medium and long term.

• Monetary: Since last June, the European Central Bank (ECB) has lowered rates eight times and by more than 200 basis points, significantly easing financial conditions. The pass-through from lower interest rates is stronger in Europe than the U.S., given the higher share of floating-rate mortgages and companies’ greater reliance on bank financing. Although the ECB signaled a summer pause, they still have room to cut rates this year, given stable inflation dynamics, especially if tariff tensions rise.
• Fiscal: While some markets, such as the UK, face consolidation pressures, Germany, the main fiscal hawk, is shifting, having removed the “debt-brake” earlier this year and committed 500 billion euros to a special infrastructure fund. Meanwhile, North Atlantic Treaty Organization (NATO) members aim to raise defense spending to 5% of gross domestic product (GDP) by 2030, a significant increase from current levels. However, it is not clear how much defense spending will benefit domestic versus foreign companies given the capacity constraints. Nonetheless, the move away from fiscal conservatism should support private sector confidence and boost growth in the medium term. 
• Regulation: Regulation has long been seen as an obstacle to faster productivity growth, weighing on corporate investment and adding to the decline in competitiveness. In recent years, the European Commission launched the “Better Regulation” agenda, with proposals like the “Simplification Package” streamlining ESG reporting and reducing regulatory complexities. While regulatory easing may be the slowest of the three aspects, reducing inefficiencies and boosting productivity is crucial for long-term growth.

Investment implications

Europe's near-term macroeconomic outlook remains mixed, influenced by the reversal of significant front-loading of exports in 1Q25 and potential tariff risks, while fiscal and monetary easing mitigates a sharper slowdown. Structural policy shifts and positive investment sentiment are progressing, with valuations and flows suggesting that portfolio rebalancing away from the U.S. has further to run. However, investors should be mindful of the varied tariff impacts and macro tailwinds across sectors, utilizing active stock-picking to capitalize on long-term opportunities in the region.

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