Is a European renaissance on the horizon?

It has been a tough start to the year for the US market. The dominant Magnificent Seven stocks are down 3.4 per cent for the year to the end of February, while the S&P 500 is up just 1.7 per cent.

Where has capital gone instead? A little bit has gone to the UK, with the FTSE All Share up 5.0 per cent, but the big gains have been seen in European markets with the Euro STOXX 50 up 11.8 per cent. Could this be the start of a European renaissance?

If so, it is coming at an unusual time. The political situation in Europe has seldom looked more fragile.

The situation in Europe is unattractive, and there are still plenty of risks.

The US administration appears to be pursuing a peace-at-any-price deal with Russian President Vladimir Putin. Far right parties are gaining ground across the continent, including Germany’s AfD party securing a 20 per cent vote share in the latest election.

The region needs to make a significantly greater commitment to defence spending, and its companies are facing the potential imposition of tariffs. It is not an obvious backdrop for stock markets to make progress. 

On the other hand, David Walton, manager of the IFSL Marlborough European Special Situations fund, points out that lower inflation figures are supporting confidence in European markets.

While inflationary pressures are making further US rate cuts look increasingly unlikely, the European Central Bank may be gearing up for its sixth rate cut since June last year. He says there has also been less concern about the potential for Trump tariffs.

Walton says these factors have driven gains for certain parts of the market. “With banks and large export-led companies the primary beneficiaries of these factors, larger-cap companies generally outperformed smaller ones.”  

Nevertheless, slower price rises have helped some companies improve profitability, as input-cost inflation has fallen. He says this will continue, particularly for smaller companies: “This backdrop could be expected to benefit the earnings of smaller companies due to their generally greater use of labour and variable rate debt relative to larger companies.”

The German question

Germany may prove important to any renaissance. The country has been mired in economic and political stagnation for much of the past two to three years.

Its manufacturing base has been dented by increasing protectionism from China and the US.

Low public investment and an inflexibility on spending have also held back economic growth. 

Robert Schramm-Fuchs, a manager on the European Focus fund at Janus Henderson, says: “Germany had its last set of structural reforms back in 2003 and 2004. What they called ‘Agenda 2010’, under Chancellor Schröder at the time. Now the governments after that, the Merkel years, and now the recent period under Chancellor Scholz, have essentially lived off that reform agenda of 20 years ago, and diluted it over time.

“And so Germany’s competitive position and labour productivity, and so on, became worse and worse. Germany became the sick man of Europe again, like it was in the 1990s.”

The actions of US President Donald Trump’s administration may be enough to galvanise Germany’s new government under Friedrich Merz to spend.

The incoming chancellor has said he wants a definitive break with the US. He may take a more business-friendly approach and encourage greater reliance on private sector-driven growth.

The hope is that he will channel government capital towards strategic sectors such as energy, infrastructure and technology.

Germany had already been starting to show signs of life, albeit from a low base. The HCOB Germany Manufacturing PMI rose to 46.1 in February 2025 from 45 in January. This was ahead of market expectations and the highest reading in 24 months.

Poor sentiment

Rob Burnett, manager on the Lightman European fund, points out that investors’ allocations and sentiment towards Europe are weak. “Trump’s victory and the promise of US deregulation and tax cuts have seen large investor allocations out of Europe and the rest of the world into the US, as shown by the movement in the currency market.”

The turnaround experienced this year is a relatively new phenomenon, with Europe significantly underperforming the US in 2024. 

Alongside a potential recovery in Germany, Burnett sees a number of other potential catalysts that could cause capital to return to Europe in 2025 – a possible end to the Russo-Ukrainian war, for example.

He says: “Any kind of peace will see some relief in Europe, with a large Ukrainian reconstruction to follow, supporting economic growth. Precautionary savings rates are very high in nearby countries like Germany and Poland, and the end of the war could see consumer confidence recover.”

Stronger Chinese consumption is also an overlooked factor for European companies.

As the Chinese government looks to support property prices, consumers may once again have sufficient confidence to spend. “The combination of lower interest rates and the state buying unsold housing inventory could stop the decline in Chinese house prices in 2025.

“This may improve Chinese consumer confidence and spending compared to expectations, which could benefit European industry,” says Burnett.

The final factor is valuations, with European stocks still at a record discount relative to the US.

Burnett’s view: “If European equities were to return to their 30-year average discount to the US, they could outperform the US by 77 per cent. If Europe was to return to its relative valuation in 2007, it could outperform by over 160 per cent.”

The situation in Europe is unattractive, and there are still plenty of risks. However, those risks are not unique to Europe, and valuations are far lower there.

There are also catalysts for change across Europe.

It may be too much to say that the run of stronger performance is the start of a renaissance, but it should at least give investors pause for thought on their low weightings. 

Darius McDermott is managing director of FundCalibre and Chelsea Financial Services