European Equities: Poised for Continued Progress Amid a Possible Pause

At the start of the year, we highlighted European equities as an overlooked opportunity—misunderstood and undervalued relative to global peers, with subdued valuations and muted fund flows despite favourable monetary and fiscal conditions. In our thought piece, Europe’s Quiet Revolution, we also argued that Europe was at an inflection point, driven by more shareholder-friendly corporate strategies.

Performance so far this year has validated this view in a sign that investors are recognising the region’s potential. European equities have been among the best-performing global asset classes year-to-date. When coupled with the strength of the euro, their performance looks even more impressive (Exhibit 1). 

However, periods of outperformance are rarely linear. We believe European markets are now entering a natural consolidation phase, or an “air pocket,” as investors recalibrate after recent gains and adjust to the European Central Bank’s (ECB) apparent end to its rate-cutting cycle. While this pause may temper near-term momentum relative to the US where rates are falling again, Europe’s longer-term story remains intact, supported by structural catalysts.

Monetary Leadership Creates a Base on Which to Build

A key driver of Europe’s strong performance this year has been its proactive monetary policy. The ECB moved ahead of the US in adjusting interest rates earlier in the cycle and these measures are now starting to flow through to the real economy. The manufacturing sector is finally moving into expansionary territory following three years of decline (Exhibit 2).

Meanwhile, loan growth is accelerating. For instance, Spain has shifted from negative loan growth to a robust 3% year-on-year, while Greece has achieved an impressive 12% growth (Exhibit 3). Germany’s construction and housing sectors are also benefiting from stable borrowing costs and government incentives.

Investors, however, often grow impatient with the lag between policy changes and economic data. While rate cuts can spark initial optimism, markets can take time to reflect any positive impact. We expect the broader economy to continue to gain momentum as the full impact of earlier rate adjustments becomes increasingly evident in the years ahead.

Political Developments: Progress Amid Distractions

Political uncertainty in France has drawn headlines, but the reality is far less disruptive. The inability to build a consensus among the various political parties in the assembly—as evidenced by the changes in prime ministers—has not led to a government collapse. The distinction is important: while leadership may change, the government remains in place, ensuring that essential spending plans remain largely intact.

From an equity market perspective, the reaction to increased borrowing costs in France has largely been exaggerated, in our view. A meaningful proportion of listed companies in France are internationally focused, with limited exposure to the domestic economy. Their performance is more tied to global conditions than to the nuances of French politics or borrowing dynamics. We see the situation as a distraction rather than a lasting risk.

Germany’s fiscal reform and increased public spending offers a more constructive narrative. While announcements initially sparked optimism, enthusiasm has since faded as such legislation often takes time to pass through parliament—especially over the summer months. However, once the legislation is passed, we expect renewed investor interest and a positive market response as these measures take shape over the longer term.

Fiscal Reforms Pave the Way for Broader Sector Gains

Looking ahead, the momentum behind these fiscal reforms is expected to build, providing a supportive tailwind for European equities. Increased government spending should benefit sectors such as infrastructure, capital goods, and construction, while serving as a catalyst for broader market performance. While banks and defence stocks have driven much of the gains in European equities so far this year, the medium-term outlook suggests a broadening of market leadership as domestic and international growth takes hold.

Valuations Continue to Bolster Long-Term Appeal

Despite strong performance year-to-date, European equities remain attractively valued, especially relative to the US, where concentrated growth and elevated P/E ratios persist. Earnings upgrades have kept valuations in check in Europe, while generous dividend yields further strengthen the investment case for the region.

Risks such as trade disputes and geopolitical uncertainties remain challenges for export-driven economies like Germany, while a weakening US dollar could create pressures for sectors with significant international exposure. Still, we believe they are outweighed by Europe’s strengthening structural position. Fiscal initiatives, shareholder-friendly corporate practices, stabilising economic activity, and attractive valuations reinforce Europe’s long-term investment appeal.