European equities: time to reassess?

Investors are at best lukewarm when it comes to Europe. True, European equities outperformed the US market in 2025, but overall sentiment remains weak as Europe has been a source of recurring disappointment. However, we think repeated false dawns should not stop investors from considering what could go right and exploring how that could alter their overall portfolio positioning. From a multi-asset perspective, the investment case for Europe today is twofold:

1. The region offers an opportunity to diversify risk assets away from an overly concentrated US market and hedge some of the risks associated with a deteriorating US institutional framework.
2. The backdrop is slowly changing for the better after a long period of subpar growth, with tentative signs that Europe is getting serious about the need to implement much-delayed reforms. 

However, risks have not disappeared. On the contrary, Europe remains fragile in several areas. But taken together, the narrative looks more constructive.

Regime change

For most of the last decade, Europe was shaped by a deflationary mindset. Growth was weak, fiscal policy was tight and companies tended to focus on balance-sheet repair rather than expansion. This context became self-reinforcing and weighed on confidence.

What is different now is that we are not only seeing an improving cycle but also accelerating regime change. 

• Parts of Southern Europe appear to have moved past the most difficult phase of their post-eurozone-crisis adjustment and are now leading on growth. 
• Longer term, decelerating globalisation is forcing Europe to reduce its dependence on export-led growth and stimulate its domestic economy. This transition could create new opportunities for European companies.
• At the same time, the focus across the Continent has shifted away from pure fiscal restraint. Germany’s change of direction is important here, and reflects a broader European move towards security-, infrastructure- and productivity-related investment. Defence, energy security, energy grids and strategic industries are no longer marginal topics; they are becoming core policy priorities. This shift matters because it supports nominal growth and pricing power. Meanwhile, underlying dynamics suggest that inflation is stabilising at around 2%, while resilient consumer balance sheets and low unemployment mean that risks to domestic demand are tilted to the upside.

The cyclical outlook for the euro area is continuing to improve gradually. Growth indicators are lifting, supported by relatively loose financial conditions and a more expansionary fiscal stance. External headwinds — notably US tariffs and threats in relation to Greenland, the continued war in Ukraine and Chinese trade policies — remain a drag but have, so far, been manageable. And while still too slow, progress is being made in tackling some of the structural inefficiencies that are holding Europe back. 

Normalisation of the banking landscape

This regime shift is occurring against a backdrop of a recovery in European banking. European banks were hit hard by the global financial crisis as well as the subsequent eurozone crisis, with a major knock-on effect on the wider economy given banks’ role as the Continent’s key financing conduit. Conversely, they are now bellwethers of Europe’s gradual turnaround, reflecting a more stable macro environment where lending is recovering, interest rates have been cut but remain far from the low levels of the 2010s and domestic activity is improving.

Productivity gains through AI

Europe is not leading the AI race in terms of foundational models, platforms or hardware. But this does not mean AI is irrelevant for European equities. The next stage of AI development is not just about who builds the technology, but who uses it effectively. And according to Microsoft’s latest AI Diffusion Report¹, Europe is well ahead in adoption. 

Many European companies are large incumbents with data, scale and established customer bases that can be harnessed. For them, AI is less about disruption and more about improving efficiency, reducing costs and supporting margins.

Pricing power is the important variable to watch here. Companies that can adopt AI while maintaining pricing discipline are more likely to translate productivity gains into earnings. Those without pricing power risk passing the benefits to customers instead.

AI adoption is still in its early phases, and the evidence of return on investment is gradual. But over time, this could become one of the more meaningful positive forces for Europe, especially given the relatively low starting point in productivity.

Increasing strategic autonomy and competitiveness

One of the clearest step changes we’re seeing in European policy is a focus on strategic autonomy. Defence spending, energy security, grid investment and strategic supply chains are all part of this agenda. Beyond the spending itself, the challenge is coordination and speed. However, it is likely that external challenges (for instance, the US wanting to acquire Greenland) will accelerate this regime shift.

This is where recommendations put forward by former European Central Bank President Mario Draghi are relevant. His report on “The future of European competitiveness”² highlights well-known weaknesses such as fragmentation, slow decision-making and compartmentalised capital markets. Crucially, it frames them as urgent economic risks rather than long-term aspirations. So far, progress has been uneven,³ but any acceleration in implementation would materially improve Europe’s ability to translate strategic ambition into growth. Areas with the greatest potential include: 

• Savings and Investments Union — Europe’s fragmented capital markets remain a structural weakness. Better mobilisation of savings into productive investment would clearly support growth and innovation. Discussions around reform have gathered pace, and the sense of urgency has increased. 
• Internal market — The IMF estimates that intra-EU trade barriers might be as high as a tariff equivalent to about 44%, on average, for goods — three times higher than the trade barriers between US states. For services, they are equivalent to a 110% tariff. Clearly, there is potential for enormous gains here. Significant obstacles remain, but the European Commission’s new strategy⁴ for addressing the 10 most harmful internal trade barriers could yield tangible results.
• Trade deals — The imposition of US tariffs on European exports has triggered renewed urgency to reach trade deals with Latin America (Mercosur) but also Indonesia, Australia and India. While these markets currently represent a smaller proportion of Europe’s exports, they have the potential to grow over time. Concluding the long-outstanding Mercosur deal, in particular, would send a positive signal on EU cohesion and its focus on growth. 

Other potential tailwinds 

• M&A as a confidence signal — M&A activity in Europe has started to recover. While less of a direct performance driver, it nevertheless signals improving corporate confidence and willingness to deploy capital. However, further momentum could be hampered by regulations, valuation gaps and macro uncertainty.
• Energy prices — Despite some upward pressure on storage this winter, our energy analysts expect gas-based power costs to drop over the next three to five years, which would reduce commodity inflationary pressure and, at the margin, improve competitiveness. In the long run, continued development of renewable energy resources and investment in energy infrastructure should also enhance Europe’s ability to compete.
• A durable ceasefire in Ukraine — While currently still hard to achieve given Russia’s maximalist demands, the potential for a lasting ceasefire should not be entirely discounted. 

Structural headwinds remain 

At the same time, Europe still faces significant structural impediments. Most notably:

Intensifying competition from China 
One of the most underestimated constraints on European earnings is not domestic demand but global competition. Chinese manufacturers, in particular, are continuing to increase pressure across many industrial segments, often with aggressive pricing and scale advantages.

This matters for Europe because the equity market is heavily exposed to mature industrial sectors, where margins are sensitive to competition and differentiation is difficult. Even when direct revenue exposure to China is limited, the indirect impact on pricing and market share can be significant. 

While we are seeing tentative signs that Europe is willing to counter these competitive threats with more robust and coordinated industrial policies, it will not be an easy fix. This structural risk could limit the potential for a broad rebound in European earnings.

Growing demographic pressures
A rapidly ageing population is both increasingly constraining public finances through higher pension and health care expenditure and curbing labour supply amid a political backlash against further immigration. Public finance constraints could limit necessary investment, while labour shortages may translate into higher inflation and reduce competitiveness. 

Critical developments to watch here include:

• the wide-scale harnessing of resource-saving technology, including AI;
• more common EU borrowing to facilitate critical investment;
• more creative policies to help keep an ageing workforce active for longer; and
• smarter immigration policies to attract skilled workers.

Geopolitical uncertainty 
Europe’s open economy and export-led companies are particularly vulnerable to geopolitical uncertainty given the region’s reliance on both energy imports and the US security umbrella. Historically, moments of crisis have acted as catalysts for Europe to advance. Political fragmentation and the rise of eurosceptic right-wing parties are major obstacles to meaningful breakthroughs this time, but growing tensions with the US and China could still precipitate greater cohesion and reform. 

What does it mean for investors? 

• Marginal improvements matter — Numerous “what ifs” could derail the nascent recovery, but the low level of market expectations means that even marginal improvements could yield significant upside. 
• Japan offers a promising parallel — Like Europe, Japan has suffered from repeated setbacks and prolonged negative sentiment. However, we have been positive on Japan for a few years now as a shift to a higher nominal growth regime has coincided with improving corporate governance and micro-level structural reforms, all of which have driven return on equity and corporate profits higher. 
• Even small steps by Europe towards greater integration, smarter deregulation and greater openness to cross-border M&A could create micro tailwinds similar to those underway in Japan.
• A timely opportunity for active management — Meanwhile, we think that Europe’s accelerating regime change already offers significant scope for active managers to capture upside potential by leaning into the key beneficiaries of regime change while mitigating exposures to those companies or sectors likely to be the relative losers.

 ¹ “Global AI adoption in 2025”, Microsoft AI Economy Institute, 8 January 2026. | ²Mario Draghi “The future of European competitiveness”, European Commission, September 2024. | ³“One year after the Draghi report”, European Commission, September 2025. | ⁴“The Single Market: our European home market in an uncertain world”, European Commission, 21 May 2025.