Chief Global Strategist
For investors, Europe seems like a train in a station, perpetually gathering steam and loading up for a long-delayed journey, but clearly advertising only a modest pace when it gets under way. Such has been the case for the European economy and, even more so, for European equities for many years. This has, of course, been deeply frustrating for those investing in European stocks, which, while often producing OK returns, have underperformed U.S. stocks in 12 of the last 15 years.
However, the pedestrian pace of the European economy and markets could be a virtue for investors in the years ahead. Europe suffers from none of the over-building excesses that haunt the Chinese economy. European equity markets have none of the bubbly valuations that pose a threat to U.S. stocks. A starting point of a weak euro and monetary easing, combined with a high savings rate and fiscal capacity has the potential to boost both economic growth and dollar-denominated returns on European equities. Attractive dividend yields can allow European equities play a respectable role in generating income. Moreover, political pressure from within Europe, along with the threat of tariffs from the United States, could motivate bolder action from European policymakers in both deregulation and fiscal stimulus, triggering greater economic momentum.
A useful definition of diversification is investing in stuff that you hate. By that measure, for most American investors, Europe represents the perfect diversifier. However, rationally, an allocation to Europe seems like a sensible move at the start of 2025 - a bet on the land between bubble and bust, and a prudent place to add assets in a turbulent and unbalanced global investment environment.
The European Economy: Starting Slowly from a Positive Place
The overall numbers on the European economy show a region growing very slowly but cyclically in a generally good place. Real GDP across the eurozone was unchanged, quarter-to-quarter, in the fourth quarter of 2024 and up just 0.9%, year-over-year, following an anemic 0.1% gain in 2023. With very little population growth, this slow economic growth does not imply a deterioration in living standards. However, it does not suggest much momentum either.
The news on the labor market is better. The eurozone unemployment rate in December 2024, at 6.3%, is within 0.1% of its lowest level this century and total employment in the third quarter of 2024 was up a respectable 1.0% from a year earlier. Wages grew by a still hot 4.4% year-over-year in the third quarter of 2024. However, this was down from 5.1% a year earlier and, given a fall in the trade-weighted value of the euro in recent months, should not significantly undermine European competitiveness.
The inflation story also looks reassuring with year-over-year harmonized consumer prices rising by 2.4% in the year ended in December 2024, down very sharply from a peak of 10.6% in October 2022. This steady decline in inflation should also promote an easing in wage growth since local regulations and employment contracts still leave wage growth more closely tied to reported consumer inflation in Europe than in the US.
At an aggregate level, the fiscal situation in the eurozone is not particularly alarming, at least in comparison to the U.S., Japan, China or the U.K.. According to IMF estimates, the gross government debt-to-GDP ratio in the eurozone was 73.9% in 2024, down from 76.4% 10 years earlier. This stands in contrast to the U.S., the U.K., Japan and China, all of whom have seen a sharp increase in this ratio over the past decade and all of whom now have significantly higher debt burdens than the eurozone. This gives European governments, on aggregate, the opportunity to stimulate economic growth should they choose to do so.
European monetary policy is also becoming more accommodative. Last month, the European Central Bank cut its deposit rate to 2.75%, down from a peak of 4.0% that was maintained between the fall of 2023 and the spring of 2024. Moreover, futures markets are currently pricing in three further rate cuts in 2025, which should cut the rate to 2.0% - below the current CPI inflation rate. This stands in contrast to the United States where fears about the impact of trade, immigration and fiscal policies have left markets expecting just one rate cut in 2025, leaving the federal funds rate at between 4.00% and 4.25% by the end of the year.
These lower rates could help boost European growth as the European business sector is more dependent on bank financing than in the United States and a much larger share of mortgages carry a variable rate.
Eurozone economies could also benefit from a cheap euro. As of Friday, the euro closed at 1.033 dollars – lower than it has been roughly 75% of the time since 2000. While this, to an extent, represents a vote of no confidence in eurozone assets by the global financial community, it also is a good place from which to grow exports. It should be noted that the eurozone, as a whole, runs a substantial current account trade surplus.
Most importantly, Europe could benefit from having some more profligate consumers. The household saving rate in the third quarter of 2024 was 15.3%, up substantially from the 12.6% recorded in the four years before the pandemic. By contrast, the U.S. personal saving rate in the fourth quarter was just 4.1%, down from 6.2% before the pandemic. Interestingly, the problem is not one of confidence – consumer confidence appears to have fallen even more sharply from pre-pandemic levels in the United States than in Europe. It’s just that American consumers are both willing and able to spend even when they feel gloomy, while European consumers are not.
Putting it all together, Europe undoubtedly has the collective capability to grow faster – it just needs to embark on the journey.
North and South, Spenders and Savers
While many of these aggregate numbers look relatively good, they obscure two broad problems.
First, some of the biggest economies in the eurozone are suffering from slow or non-existent growth and are also facing major political challenges.
Second, while the fiscal situation in the eurozone looks relatively OK by international standards, there is a sharp divide between the countries that have relatively low debt and are determined not to increase it and their more profligate brethren.
While eurozone GDP grew by 0.9% year-over-year in the fourth quarter overall, within that Germany saw a 0.2% decline, Italy grew just 0.5% and France saw a meagre 0.7% gain.
The German economy, which accounts for almost 30% of eurozone GDP on its own, has stagnated for two years following a relatively lackluster rebound from the pandemic. Germany has always been the manufacturing/export powerhouse of the European Union. However, the combined effects of a decision to abandon nuclear power and the sudden cutoff of cheap Russian gas due to the Ukraine war has sharply raised energy costs for German manufacturing while a slowdown in China has hurt one of its key export markets. Very aggressive rules to reduce Germany’s carbon footprint have also hampered both manufacturing and construction.
Moreover, Germany has been hindered by a conservative policy on debt, with the law forbidding the government from running a primary deficit that is greater than 0.35% of GDP, despite a debt/GDP ratio that is quite low by international standards. However, energy, environmental and debt policies could all be eased in the wake of this month’s upcoming parliamentary elections.
France has been doing only marginally better as a much worse debt situation is putting pressure on the government to cut spending and raise taxes. Last summer, President Macron arguably made a bad situation worse by calling national elections following a poor showing for his ruling bloc in elections to the European Parliament. These national elections resulted in the election of very strong blocs to the left and right, making it very difficult to pass a budget at all.
Italy is also seeing just sluggish growth. While politically stable for now, Italy saw no economic growth in the second half of 2025 and suffers, like Germany, from a fast-aging population. Unlike Germany, however, the Italian government is burdened with very high debt, limiting the scope of any fiscal stimulus.
One bright spot is the Iberian Peninsula, where Spain and Portugal saw 2024 real GDP gains of 3.5% and 2.7% respectively. Tourism is a huge industry in both countries and they have benefited from a post-pandemic revival in travel. This, of course, brings challenges of its own, including a property crisis as foreign nationals buy up an inadequate supply of domestic housing. Greece and Ireland also continue to see strong growth but a chronic shortage of housing as a long-term hangover from the European debt crisis.
The Value Case for Europe
The track record of both European governments and the European economy make it hard to predict a sharp acceleration in growth. However, Europe also does not look particularly exposed to recession. Europe has not seen a recent speculative bubble in either the economy or financial markets and, having missed out on the party, can at least expect to avoid a hangover.
There is, of course, downside risk to potential U.S. tariffs. However, Europe could benefit from an end to the Ukraine war. Moreover, European governments, pressured by a domestic drift to the right, a less-friendly United States, and the military threat of Russia, may be more aggressive in both promoting deregulation and increasing defense spending which could amount to significant fiscal stimulus.
However, the strongest case for European equities is simply a value case. At the end of January, the MSCI Europe ex-UK had a forward P/E of 14.7 times compared to 21.8 times for the S&P500, a discount that is more than two standard deviations greater than its average over the past 20 years. It also sported a dividend yield of 3.3% compared to 1.3% for the S&P500.
Some of the valuation discount, of course, reflects compositional effects, since highly-valued technology stocks have a much greater weight in the S&P500 than in the MSCI Europe. However, even accounting for this, each of the 10 sectors in the MSCI Europe have a significantly lower P/E ratio than their S&P500 counterpart.
Beyond this, it is important to recognize that bear markets tend to be concentrated in the sector than dominated the previous bull market. Technology stocks fell far more than the rest of the market when the dot-com bubble burst. Financials took it on the chin more than other sectors in the Great Financial Crisis and the European Debt Crisis. Today, if there is a bubble in equity markets, it is likely concentrated in overpaying for hopes and dreams in technology stocks. That being the case, European equities that are underweight technology should be much less vulnerable if global equity markets turn south.
In short, the European economic train is still loading slowly without promising any great gains for equity investors. However, gains should at least be solid and steady and could act as a very important stabilizer for portfolios that have drifted too close to the sun on the wings of mega-cap U.S. technology stocks.