As we step into the early days of 2025, European stock markets are making headlines with performances that have outshined Wall Street for the first time in a decade, capturing global investor interest. It’s no secret that the German DAX index has surged by over 11% since the start of the year, while the pan-European Stoxx 600 index has seen a rise of more than 7%. In contrast, the S&P 500 has only managed an increase of 3.1% during the same period, showcasing a significant shift in market dynamics.
The roots of this so-called "European miracle" are grounded in a complex interplay of various factors. Firstly, European stocks have long been viewed as undervalued, and with the economy gradually recovering, companies are at last experiencing a necessary correction in their earnings, which has opened the floodgates for a considerable influx of capital into the market. Secondly, shifting geopolitical landscapes and the strategic maneuvers of different national policies are subtly shaping market trends. Yet, amidst this market euphoria, lurking risks remain ever-present. The potential imposition of U.S. tariffs threatens to hit export-driven European industries, while longstanding structural deficiencies in Europe, such as energy dependence and innovation stagnation, continue to loom like the sword of Damocles over the continent’s economic stability.
How long can this remarkable turnaround last?
The restoration of "value gaps" in asset pricing in Europe is one of the key factors driving this surge. By the close of January 2025, the expected price-to-earnings ratio for the Stoxx 600 index stood at a mere 14 times, significantly lower than the 22 times for the S&P 500, while the UK market was even more undervalued at 12 times. This stark contrast has made European stocks increasingly attractive to investors who had previously considered the region a no-go zone.
"Historically, Europe has been perceived as 'uninvestable,' but now, with improving valuations and enhanced earnings expectations, any positive development in the region is magnified," said Luca Paolini, Chief Strategist at Pictet Asset Management.
Market forecasts indicate that the growth rate for European corporate profits is set to jump from just 1% in 2024 to a promising 7.9% in 2025. Although this growth still pales in comparison to U.S. figures, the steep incline is generating renewed confidence among investors. Analysts point out that the selective impact of U.S. tariff policies has been a primary driver of this shift, noting that while the U.S. steel and aluminum tariffs cover global markets, Europe has not been targeted as a primary focus, leading to a capital migration to this perceived safe haven.
Entering 2025, the European stock market has witnessed a powerful rebound. This conclusion aligns well with the market's movements, as evidenced by a remarkable inflow of capital into European stock funds in January, marking the second-highest level of capital influx in the last 25 years. The Stoxx 600 index achieved a stellar 5.5% increase within just one month, fueled by strong demand as investors sought to recalibrate their previously undersized positions in European equities. Spotting the undervaluation in the market, they have actively poured money into these stocks, enhancing their performance and injecting life into European markets at the turn of the new year.
The prevailing policies are also acting as a catalyst for European stocks. With the European Central Bank and the Bank of England already having slashed interest rates, there exists a gap in borrowing costs that is funneling more investments into Europe, especially as the Federal Reserve remains stagnant on monetary policy adjustments.
However, despite the short-term momentum driving stocks upward, the sustainability of this euphoric phase is fraught with challenges. At the forefront is the possible reevaluation of U.S. tariff policies. Following February announcements of tariffs on Canada and Mexico, European stocks responded negatively, with the German DAX index plummeting nearly 1.9% in a single session.
"Currently, the U.S. has successfully negotiated with Australia and Mexico, but with negotiations yielding results, it is likely that attention might soon turn towards Europe. With Switzerland and Germany ranking as the fourth and fifth largest trading partners with the U.S., the looming threat of tariffs cannot be ignored,” analysts warn.
If trade tensions escalate, it will be the export-reliant European automobile sector that could bear the brunt—on the very day news of tariffs broke, shares in European automotive companies fell dramatically by as much as 11%.
State Street Global Advisors strategist Altaf Kassam commented, "If the U.S. imposes tariffs on Europe, the current rebound could collapse in an instant."
Beneath these geopolitical pressures lies a deeper ideological challenge, stemming from Europe’s own structural weaknesses. Michele Morganti, a strategist at Generali Investments, highlighted issues such as a high dependence on energy, insufficient technological investments, and an aging population. Over the past four decades, the European market has experienced multiple false dawns, rebounding only to retreat, largely due to these entrenched issues proving troublesome to resolve.
As the situation unfolds, institutional perspectives on the outlook for European stocks are starting to diverge. Marc Halperin, a fund manager at Edmond de Rothschild AM, recommends increasing holdings in cyclical stocks, stating, "The rebound in economic indicators, the easing of monetary policies, and the Federal Reserve pausing interest rate hikes will all support European stocks." Technical indicators also provide support: analyses from Sentimen Trader reveal a surge in European stocks breaking above the 50-day moving average, suggesting a potential continuation of this positive trend in the upcoming one to three months.
On the contrary, long-term investors are adopting a more cautious stance. Luca Paolini acknowledged that Europe's earnings growth rate is underwhelming compared to the U.S. and pointed out a lack of competitiveness in the technology sector, inhibiting long-term potential. Similarly, Steven Englander, an analyst at Standard Chartered Bank, raised flags, equating U.S tariffs to a player in a high-stakes poker game who has wagered all their chips, reminding investors that the market has yet to adequately price in the potential cascade of reactions that could ensue.