- Macro Strategist
United States, Institutional
Change
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European equity markets are in the middle of a radical regime change, the magnitude of which could exceed the major shifts observed in 2000 and 2008. While such transitions tend to play out over several years, the sheer scale of Europe’s geopolitical and macro backdrop challenges means that the pace of change is visibly accelerating. We are witnessing huge transformational policy initiatives in Germany and the European Union (EU) that could revive the Continent’s flagging fortunes. While the road ahead is likely to be bumpy, we are starting to see significant inflows into European equity markets as well as a rotation away from the beneficiaries of globalisation to more domestically orientated stocks. Below I set out my latest thinking on the next stage of the transition and its implications for European equity investors.
What’s driving regime change?
The environment for European equities is changing for three key reasons:
- Globalisation is slowing, a trend accelerated by increased geopolitical tensions and US President Donald Trump’s “America First” agenda. Europe’s open economy makes it particularly vulnerable to tariffs and trade restrictions.
- Monetary policy is changing. Even if further rate cuts are enacted, to support growth and limit the fallout from US tariffs, structurally higher inflation will ultimately limit central banks’ room for manoeuvre. Rates are likely to be meaningfully higher compared to the decade after the global financial crisis when unusually loose monetary policy kept rates low.
- Europe is rapidly becoming more domestically focused and interventionist. A more challenging international environment and the deteriorating relationship with the US mean that national security, economic resilience and competitiveness are now key priorities for European policymakers. Longer term, the energy transition, the need for greater climate resilience and the impact of ageing populations are further catalysts for change.
In my view, there is no doubt that these trends are accelerating based on several key developments.
The extent and speed of the European policy reaction
Escalating trade tensions, the new US administration’s growing reluctance to support Ukraine and Europe’s security, as well as Europe’s obvious lack of competitiveness, have forced European policymakers to take ever bolder steps to support domestic demand and improve national security, notably:
- Germany’s U-turn on fiscal policy — The new government has announced a €500 billion infrastructure package over 10 years (equivalent to 12.5% of GDP) and has secured a relaxation of the constitutionally enshrined German debt brake, with unlimited defence spending. This pivotal development — unthinkable just a year ago — is likely to boost German domestic demand and could structurally lift trend growth in Germany and, by extension, the euro area.
- Rearming Europe — Until six months ago, defence was mainly seen as a national issue. Now, the European Commission has proposed mobilising up to €800 billion for European defence. The plan includes an EU financed fund for key priorities such as air defence, missiles and drones, and would exempt national defence spending from the EU’s fiscal rules.
- More flexibility around state aid and less regulation — The European Commission has released its Competitiveness Compass, which aims to improve and reduce regulation, break down single market barriers and enhance access to risk capital (including by creating an EU capital markets union). The Commission also wants to support any “strategic” sector deemed essential to the EU’s economic security. To fund these efforts, the Commission has called for a more flexible state aid framework, a clear departure from its standard policy of limiting state aid.
While there are likely to be setbacks, particularly when it comes to coordinating efforts at the EU level, I believe that the existential nature of the challenges Europe faces makes following through on these steps far more likely. I expect most of the funding and regulatory support to be concentrated in three key areas: defence, energy independence and digitalisation.
The escalating trade war
Global trade as a proportion of GDP has been flatlining since the global financial crisis, with rising geopolitical tension becoming an increasing problem for international businesses and supply chains. The magnitude and speed at which the US is now seeking to implement its “America First” trade agenda is a major additional headwind for globalisation. In my opinion, it will result in less international trade, less efficient supply chains and more fragmentation. Europe’s open economy is particularly vulnerable to an escalating trade war and displacement of Chinese exports from the US to Europe. Moreover, while for a long time their international reach was a clear positive for European companies — think, for example, industrials and luxury goods — this relative advantage is disappearing fast. In response, policymakers are seeking to raise domestic demand and boost European capabilities in crucial areas such as defence and the energy transition.
Structurally tighter monetary policy
Europe’s efforts to boost domestic demand come at a time when European labour markets are already tight — unemployment is at a multi-decade low, immigration is increasingly difficult and demographic change means the labour force is shrinking for the first time since the Second World War. Germany is one of the most extreme cases with German unemployment close to a 30-year low Figure 1 at a time when the government is launching a massive fiscal stimulus package.
It is hard to see how a scenario of potentially higher domestic demand and a tighter labour force is not inflationary. My base case remains that the European Central Bank will seek to cut rates by another 75 basis points in 2025, but rates are likely to be structurally higher in the medium term on the back of higher inflation and increased government debt issuance.
Figure 1
Who are the likely winners and losers?
In combination, I expect these drivers to have a significant impact on European financial assets, which are starting to benefit from increased investor interest. In European equity markets, I anticipate a rotation away from companies that benefited the most from globalisation and lower interest rates to select value stocks such as banks and telecoms, defence stocks, small caps and enablers of the energy transition that are protected by high barriers to entry.
However, I do not expect this rotation to be a uniform or smooth process, suggesting the need for rigorous risk management and careful stock selection based on an in-depth analysis of the precise impact of this regime at both sector and stock level.
How far can Europe’s rerating go?
European equities have seen a marginal rerating since the beginning of the year from unusually depressed levels and valuations are now broadly in line with their 30-year norm. The rerating relative to the US equity market has been slightly more significant on a sector-adjusted basis, but Europe continues to trade more than one standard deviation below the norm versus the US market. I believe the rerating is justified as valuations at the end of 2024 — at levels last seen during the euro crisis — were clearly too low, given improving financial conditions, strong consumer balance sheets and an improving construction sector. More recently, valuations increased further on the back of the German fiscal announcement.
Looking ahead, we may see some pullback as investor sentiment stabilises, with certain sectors such as defence potentially overbought. However, I think the structural case for Europe remains robust. There is clearly some uncertainty about how successful the German fiscal package will be over the long term, but it has real potential to put German and European growth on an improving trajectory. Likewise, our global industry analysts believe that the European defence sector and associated industrials still offer ample opportunity for long-term growth as Europe is seeking to both shore up its defences and reduce its dependence on the US. However, that build-out will take time to materialise given constraints in manpower, expertise and materials supply.
At present, I see the greatest scope for rerating in the value segment of the market as, according to DataStream data, European value stocks still trade one standard deviation below their norm on an absolute 12-month forward P/E basis. There are, of course, good reasons why some European value sectors are cheap — for instance, European autos — but I still think that European value offers investors the biggest stock-picking opportunity set in this new European regime.
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