Still opportunities in European equities? Positioning is key

European equities are back from the cold as investors increasingly recognise the region’s renewed potential — so much so that European equity indices are starting to look tactically extended, particularly given some near-term headwinds.

While I think the case for Europe remains compelling, investors now need to focus on company fundamentals rather than relying on positive momentum. With Europe in the middle of a regime change, portfolio positioning also matters greatly, in my view, as it can help capture the benefits of the new European economic model that is starting to emerge.

Below I share my framework on what that may mean in practice.

The case for Europe remains compelling

I see three reasons (in descending order of importance) that underpin the continued case for Europe:

1. Structural regime change — I believe Europe is starting to step up to its major geopolitical and macroeconomic challenges, moving away from its over-reliance on exports towards a more domestically focused growth model with greater fiscal support and European coordination.
2. Diversification potential — In a diverging and less stable world, Europe provides global investors with significant diversification opportunities as evidenced by growing flows from allocators looking to reduce dependence on US exceptionalism.
3. Valuations — Setting aside short-term concerns, valuations for the most part remain attractive on both an absolute and relative basis.

Beware of growing divergence between European equities

After the recent rally, the trajectory ahead may be less straightforward and will, in my opinion, require a greater emphasis on positioning along with detailed company analysis.

• Earnings downgrades — Europe appears more exposed to near-term headwinds than other regions, as evidenced by the higher number of downgrades to earnings forecasts.
• Regime change’s differing impact — The structural changes occurring today in Europe are helping some sectors and companies more than others. Broadly speaking, international companies are losing out, while more domestically focused companies and sectors are benefiting.

Be mindful of near-term challenges

Below are some of the main negative trends that I am monitoring given their potential impact on European earnings and valuations:

• A slowing global cycle — Given the high proportion of international companies, European equity markets tend to be very sensitive to the global cycle. Global economic momentum has started to slow as trade uncertainty and rising geopolitical tensions are weighing on economic activity.
• Strengthening European currencies — With European companies generating the majority of their revenues abroad, a weakening US dollar and stronger European currencies are a clear headwind.
• Higher interest rates — Despite recent rate cuts and tight credit spreads, rates are still higher than before, raising the cost of (re)financing.

Why European domestic demand could offset these concerns into 2026

After prolonged weakness, I expect European domestic demand to accelerate into 2026, offsetting some of the above headwinds. Key considerations underpinning my more optimistic view include:

• Germany’s fiscal U-turn — Earlier this year, Germany announced a major fiscal policy reboot. After years of austerity, it now plans to spend about 25% of GDP on infrastructure and defence projects over the coming decade. While there are undoubtedly implementation challenges, I believe this large-scale spending programme has the potential to lift German and European growth meaningfully, offsetting some of the damage caused by the tariffs shock. We could see the first effects perhaps as soon as next year, given the government’s focus on local investments that have an immediate and visible impact.
• Monetary easing — European monetary conditions are already pointing to an improvement in economic momentum. If, as I expect, inflation falls further, additional easing is likely. This should support domestic growth as Europe is geared towards short-term rates; both companies and households rely substantially on shorter-term floating-rate debt. In a telling sign, European construction activity has started to recover.
• Robust household finances — European consumers have accumulated sizeable excess savings, and household balance sheets are the strongest in more than two decades. Falling rates, rising house prices and the end of the energy shock should support consumption and allow for a partial normalisation in the savings ratio. On some measures, euro-area consumer loan growth is already running ahead of the US.
• A recovery in manufacturing — Manufacturing has been a drag on European growth for several years, but economic leads have recently begun to show signs of a recovery as order backlogs and inventories appear to be stabilising. This is from very low levels, but they are the clearest signs of a trough in four years.

What does all this mean for positioning?

Below are some broad principles I suggest investors bear in mind:

• Favour domestically-focused companies — Domestic companies are already experiencing significantly stronger earnings momentum than their international peers, which bodes well for their stock prices given that I expect domestic growth to pick up next year.
• Look for robust margins — Margin forecasts for many European companies look extended in a historical context. While some of this expected margin growth is structural, I see this as a near-term risk, particularly when combined with expensive valuations. Capital goods, software and commercial services stand out as areas of concern here.
• Align with regime-change beneficiaries — Along with sectors that are geared towards domestic demand, such as telecoms, banks and construction, I see select defence stocks and utilities with high barriers to entry as likely key winners of Europe’s transformation. With some notable exceptions, many of these stocks still look cheap from a longer-term perspective.
• Avoid erstwhile winners — Conversely, I think valuations of large export-orientated names in sectors such as luxury goods and autos have still not adjusted to the new world of slowing globalisation and higher trade barriers. I would also avoid growth companies that rely on cheap financing, as structurally higher inflation is likely limiting how far interest rates can fall.

In essence

The case for Europe remains strong, but greater selectivity and careful positioning are needed to mitigate both the impact of current headwinds and optimise exposure to the new opportunities that Europe’s regime change is generating.