Why European stocks are poised to outshine the United States
For a number of years, European equities have lagged behind their US counterparts, plagued by structural challenges and geopolitical uncertainties. However, recent developments suggest a potential shift in fortunes. As the US faces economic policy uncertainty and weakening consumer trends, European markets are poised for a resurgence. This article explores the factors contributing to this potential turnaround and why European equities are likely to outperform US stocks in the near term.
Historical Underperformance
European equity markets have underperformed US equity by approximately 40% since the beginning of 2020. The US has benefited from extraordinary post-COVID monetary and fiscal stimulus, higher consumer spending, and the prospect of higher growth from innovation in artificial intelligence. These factors have led to significantly more investment flows into US equity compared to Europe over the past few years.
Source: Bloomberg
Challenges Facing Europe
While the US was benefiting from stimulus and technology-led tailwinds, Europe struggled with an energy crisis brought about by Russia’s invasion of Ukraine. This culminated in restrictive monetary policy as the ECB increased interest rates to combat higher inflation, weakening consumption and leading to a slowdown in investment. Declining labour productivity also impacted competitiveness relative to the US and Asia. Increased geopolitical risks and a lack of unified political leadership deterred meaningful private investment, and manufacturing output continued to contract as a result.
German manufacturing firms’ assessment of business confidence levels indicated a weakening environment
Source: Bloomberg, Matrix
Recent Shifts in US Market Dynamics
More recently, trade and economic policy uncertainty in the US is raising the risk of a US growth slowdown and stoking inflation fears. Weakening US consumer trends are emerging, along with rising delinquencies and falling consumer confidence. This could lead to further weakening in earnings momentum in US companies. The risk to high earnings expectations and valuations of US technology stocks has also been highlighted by new competitors, such as DeepSeek, which are increasing efficiencies and lowering monetisation potential, threatening the return on investment on new AI-related investments.
US Consumer confidence is falling
The next graph shows the University of Michigan Consumer Sentiment Index over time:
Source: Bloomberg, Matrix
US recent fiscal spending has resulted in US debt to GDP growing way above pre-covid levels
This graph shows how the US Government’s level of debt has increased relative to the Europe:
Source: Bloomberg, Matrix
Aggressive fiscal spending cuts in the US aimed at reducing reliance on fiscal stimulus could also negatively impact US growth in the near term. While equity markets have started to weaken, no immediate support seems forthcoming, with officials accepting economic weakness as justified by broader objectives.
Valuation and Earnings Momentum
US equity markets now appear to be trading at a significant premium, with a forward Price to Earnings (PE) ratio of 21x for the S&P 500 compared to 15x for the Stoxx 50. This valuation mismatch is compounded by the fact that the earnings base of the S&P 500 is at historically high levels. Even if we compare equal weighted S&P 500 forward PE ratios, US equity is still trading at an 18% premium to Europe.
While the investment case for US equity is deteriorating at the margin, the case for European equity seems to be improving. Europe is deeper into an interest rate cutting cycle with further monetary policy action likely stemming from a weaker external environment as well as tariff threats from the US. European relative earnings momentum is strengthening, albeit from low levels, while US earnings momentum is stalling.
The 12-month forward PE of the S&P 500 at a significant premium to the Stoxx 50
Source: Matrix, Bloomberg
European earnings revisions are improving relative to the US
Source: Morgan Stanley
Potential Catalysts for a European Recovery
Further catalysts could emerge from a positive resolution of the Ukraine-Russia conflict, potentially leading to gains from investments in rebuilding Ukraine and easing inflation through lower gas prices.
A European recovery could also be bolstered by Germany’s plans to invest up to €1 trillion in spending through exempting defence spending above 1% of GDP from constitutional debt rules and establishing a €500 billion infrastructure fund. An emergency meeting of the outgoing Bundestag on the 17th of March voted in favour of approving Chancellor-in-waiting Friederich Merz’s plan. This stimulus could be the catalyst for Germany to turn its slowing economy around.
However, there remains uncertainty about whether other European countries will follow Germany’s lead, with some countries still spending significantly below 2% of GDP on defence (the NATO investment pledge). Discussions to bring increased defence spending to the rest of the EU are ongoing, but the lack of a unified European army or targets complicates these efforts.
Long-term Challenges but Near-term Tailwinds
Despite these potential catalysts, Europe still faces long-term structural challenges, including stagnating labour productivity and demographic headwinds from a shrinking labour force. High public debt levels in some countries are also proving to be restrictive.
Nonetheless, supportive monetary environments, increased spending on infrastructure and defence, and potential tailwinds from the resolution of the Ukraine-Russia conflict should result in European equities continuing to outperform US equities over the near term, in our view.
