Investors weigh up Europe’s investment appeal in a volatile market

Europe is looking increasingly attractive for portfolio investors previously biased to the US, but they must be prepared to act quickly in response to fast-changing political factors.

Investor interest in European stocks is rising, driven by increased defence and infrastructure spending, hopes for a Russia-Ukraine resolution and post-war reconstruction.

“At the start of the year, we saw Europe as an optional opportunity, but it is now becoming a reality,” says Pictet’s chief investment officer César Pérez. “One of the best things to happen to Europe was Trump’s election — it forced European leaders to take action.”

Markets are already pricing in stronger growth, driven by investment and a potential rebound in consumer confidence. Peace in Ukraine could accelerate this recovery, lifting sentiment and benefiting certain sectors. “It’s crucial to be selective with European stocks, favouring those linked to domestic consumption while maintaining exposure to cyclicals. European defence looks more attractive than US defence. The focus should be on banks and luxury goods, while avoiding oil and certain multinationals,” he says.

Tariffs will be sector-specific, impacting autos, healthcare, agricultural and defence. “Other parts of the economy won't be affected that much.”

While European equities have outperformed their US counterparts this year, they remain fairly valued rather than overpriced, says Bernd Meyer, chief investment strategist at Berenberg Wealth and Asset Management.

Fund flows indicate growing interest in European markets. The sentiment-driven rally in Europe could gain further momentum if structural reforms — such as Germany’s new fiscal stimulus package — are successfully implemented, he says. “If Europe can transition from a sentiment-driven rebound to a fundamentally positive growth story, European equities should continue outperforming,” he adds.

Mr Meyer expects lower equity returns than 2024 but sees greater upside in European and emerging market stocks. “We do not expect a repeat of last year’s 20 per cent gains in the US. With no room for valuation expansion, US equity returns are likely to be capped at 5-8 per cent, driven solely by earnings growth.”

However, Tracie McMillion, head of global asset allocation strategy at Wells Fargo Investment Institute, cautions that optimism in European stocks may already be priced in. She also highlights the risk of a potential blanket 25 per cent US tariff on European goods, which could dampen momentum.

Long term prospects

Nearly half of private bank CIOs in this year’s PWM Global Asset Tracker survey consider European equities attractive or very attractive.

European equity markets have significantly outperformed their US counterparts since Donald Trump's election victory and the Republican sweep last November, says Beat Wittman, CEO and founder of Porta Advisors in Switzerland.

While a market correction is possible after such a strong rally, he believes the "breakout" is real, driven by large-scale expansion in Berlin and Brussels. Increased investment in defence and infrastructure will fill the "longstanding hole" in European domestic spending.

European defence stocks, he notes, have already outpaced the US Magnificent 7 tech stocks, and this trend is set to continue.

One major catalyst is Mr Trump's stance on Ukraine, which has reinforced European unity and accelerated the move towards strategic autonomy in defence. "Europe will massively increase military spending, from an average of 2 per cent of GDP to 3.5-5 per cent, while overcoming inefficiencies in the defence industry," believes Mr Wittman.

This means more production and procurement will take place within Europe, reducing reliance on US contractors.

He argues that Europe has long suffered from underinvestment in critical infrastructure, banking and capital markets. Yet, in times of crisis, the EU has shown a capacity for decisive action. Just as the 2009-10 eurozone crisis prompted the ECB's "whatever it takes" intervention, Germany is now leading a historic shift by bypassing its debt brake rule to finance large-scale and infrastructure programmes.

It is no coincidence, he says, that Friedrich Merz, Germany's chancellor-in-waiting, echoed those same words to announce Germany’s commitment of hundreds of billions in spending.

Mr Wittmann sees structural reforms as central to Europe’s resurgence. “Europe must invest in defence and infrastructure, pursue deregulation, and foster a more business-friendly environment,” he says.

He highlights investment opportunities in the military-industrial complex, cyber defence, space technology, and artificial intelligence.

He is particularly bullish on the European military-industrial sector, predicting a sharp increase in defence spending in response to Russia’s military threat and a diminished US presence in Europe. Ukraine, he argues, will play an increasingly critical role - not only as a hub for defence-tech innovation and military hardware production but also as a strategic asset for Europe.

Banking also presents opportunities, with industry consolidation and progress towards a European banking union offering growth potential. Europe’s fragmented capital markets remain a challenge, often driving companies to list in the US.

A more unified market, however, could strengthen the euro’s position as a global reserve currency. “Europe moves two steps forward, one step back - but change is happening," says Mr Wittman.

"Germany, long lagging, and a stagnating Europe are on the cusp of decisive reforms. Falling inflation, low interest rates, attractive valuations, and underweight portfolio exposures provide a supportive backdrop for growth.”

Big picture trends

Once a background concern, politics has become a driving force in investment strategy. “Politics now play a larger role in investment decisions, requiring investors to pivot quickly,” says Pictet’s Mr Perez. He increasingly consults with emerging market investors, whose experience in managing geopolitical risk is now just as relevant in developed markets.

Markets today are noisy, but real news demands quick action. “Small dips? I ignore them. Major shifts, like German policy changes? You act fast — markets don’t wait. Acting pre-emptively, as we did with rates and European allocation, is even better.”

Berenberg’s Mr Meyer echoes this sentiment: “Trump generates daily headlines, making it tempting to react to every development. Instead, we focus on bigger-picture trends, such as the weakening dollar.”

David Storm, CIO of RBC Wealth Management Europe, expects 2025 to be “a trader’s market”, where success depends on seizing opportunities amid shifting conditions. He sees the new US administration exporting volatility and high rates, much like in 2016-2020, and argues that policy-driven uncertainty is fuelling global market turbulence.

Markets are increasingly vulnerable to extreme narrative swings, with 2024’s rate moves offering a prime example. “These over-extended shifts create opportunities,” he says. The approach is to “dynamically manage exposures, diversify across return drivers, and focus on companies set to benefit from policy changes”.