European equities enjoyed a strong start to 2025, with MSCI Europe up 6 per cent in local currency terms (and 10 per cent in US dollars) over the first quarter of the year. This follows a prolonged period of European underperformance compared to the US, which had pushed the valuation discount on European stocks versus their US counterparts to a record wide of 40 per cent.
Europe’s recent outperformance has led investors to ask whether the period of US exceptionalism is coming to an end, and therefore whether it is time to increase their allocations to European equities.
In our view, the policy backdrop in Europe has significantly improved, despite trade-related risks.
European policy looks positive
The most significant improvement in the European policy backdrop has been in regard to fiscal stimulus.
This shift is most obvious in Germany, where the incoming government’s plans make possible an expansion in the German deficit of around 2.5 percentage points.
Elsewhere in Europe, the European Commission has proposed easing the EU’s fiscal rules and setting up a €150bn (£128bn) defence loan programme.
Monetary policy in Europe also appears likely to ease further. Indeed, Eurozone loan growth has already begun to pick up meaningfully as past rate cuts feed through to credit demand.
And regulatory policy in Europe looks set to become less stringent. For example, the European Commission is planning to remove many of the burdens imposed by the bloc’s GDPR. The UK is following suit, having recently announced an easing in its electric vehicle targets.
Interestingly, while European valuations have risen from their January lows, investors do not yet seem to be fully appreciating the continent’s policy shifts.
The chart below shows the valuation discount of each sector in the MSCI Europe index compared to its S&P 500 counterpart, to allow like-for-like comparisons. While these discounts have narrowed somewhat, the move has not been major, and discounts remain historically elevated.
In my view, there is potential for further European equity outperformance, as the magnitude of recent policy shifts and their economic (and earnings) impact becomes clear.
Importantly, this upside can be best be captured via an active approach, both to minimise the impact of elevated trade tensions and to best take advantage of supportive policy.
Selectivity manages trade and policy shifts
First, ongoing changes in US trade policy will affect certain sectors and firms more than others. For example, the share of revenues generated in the US varies from 12 per cent for European utilities to 44 per cent for the healthcare sector. And at a company level, US-derived revenues vary even more widely.
Beyond revenue exposure, European firms with US-based production facilities are better positioned for trade uncertainty.
Take European automakers. Some produce a majority of their US-sold cars in America, minimising the impact of autos tariffs. Others primarily import finished cars into the US, and are therefore more exposed to the US administration’s trade policies.
More specifically, automakers importing from Mexico and Canada are currently partially sheltered by tariff exemptions relating to the USMCA agreement, those importing from Europe are not.
European firms with fewer direct US competitors, or those who enjoy less price-sensitive demand, should also be more resilient to ongoing trade tensions. The luxury goods sector provides a good example: demand is relatively price insensitive, and luxury consumers are already accustomed to regional price differentials.
And within the sector, some firms are less exposed to US competition than others. Demand for high-end Italian leather goods is at least partly linked to their being produced in Italy, for example. US leather goods do not have quite the same allure.
Policy support will also benefit some European firms more than others. Consider Germany’s fiscal push: the government-in-waiting has proposed electricity price cuts, supporting (for example) downtrodden energy-intensive chemicals firms – not the most obvious beneficiaries of an infrastructure build out.
The European Commission’s defence proposals provide another example. These envision the European Investment Bank broadening its lending to include investments in areas such as cyber security – a boost for firms beyond just tank producers and aircraft manufacturers.
And on the regulatory side, amendments to the EU’s sustainability legislation will abolish sector-specific reporting requirements. This is especially positive for firms in sectors previously facing the most burdensome obligations.
Overall, the policy outlook in Europe has picked up significantly over the past few months. This should provide further support for the continent’s stock markets.
But future upside will require a selective approach; both to be reactive to changes in the global trade landscape, and to lean into those firms best placed to benefit from ongoing policy shifts.
Natasha May is a market analyst at JPMorgan Asset Management
