Has Europe’s time arrived?

Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

What a start to 2025 for Europe. After many false dawns, the bloc’s equity markets have outperformed the S&P 500, despite the latter’s string of tech heavyweights. The continent’s largest economy, Germany, has just voted for a change of government. 

But perhaps the biggest risk is a seeming new world order in the making, as the US negotiates with Russia directly over peace in Ukraine. So, despite the geopolitical shifts underway, how sustainable is the rally in European shares?

German election – positive news? 

The German election result was largely as predicted. The conservative Christian Democratic Union of Germany (CDU)/Christian Social Union (CSU) won the biggest share of the votes. The far-right Alternative for Germany (AfD) party was forecast to do well. In the end, it got a decent share of the vote, but not enough to spark market worries. 

At a time of weak German economic growth and defence expenditure creeping up the political agenda, it was hoped that the election would pave the way to remove the so-called debt break. This could then let the government spend more. But, with negotiations over forming the next German government in full swing now, this talk might be premature. The populist parties (the AfD and Linke) have enough parliamentary seats to potentially block fiscal reforms.

Game changer

In the run-up to the German election, the US administration’s decision to deal with Moscow directly, to initiate Ukrainian peace talks, led to frantic discussions between Europe’s leaders. Such a sharp policy shift in post-second world war affairs, suggests that the continent might not be able to rely on American support in times of need. Furthermore, the considerable uncertainty over the shape of a peace deal, and what it means for power politics, could increase market volatility.

This year’s outperformance by European equity markets has much to do with returns seen by the German market and by defence stocks. European capitals are reassessing defence budgets in light of the recent geopolitical developments. The defence sector should therefore be a winner of any ‘new world order’. 

But the potential ramifications are likely to affect many sectors, and not just defence. As such, a new world order could be a golden opportunity for Europe to reshape its alliances and dependencies. In turn, potentially affecting the continent’s sources of energy to end-demand exposure. However, there are challenges. While more spending on rearming the region might be welcome, as for kick-starting economic growth, such expenditure has a poor record of improving productivity and long-term expansion.

Misplaced optimism? 

Investor momentum, or herd mentality, can be a strong influence in markets. There has undoubtedly been increased popularity for European stocks in recent months. At a time when the economic outlook is not much better than it was a few months ago. Indeed, many are still likely to be underweight the area. So, there is more scope for higher inflows, which could in turn sustain the outperformance. 

The market reaction, or lack of it, to February’s German vote did little to douse the optimism over the region. European stocks still trade at a historical discount to US equities, despite their three-month rally. The Euro Stoxx 50, an index of the 50 highest-capitalised European companies, now trades at a 30% discount to the S&P 500 (versus 40% in November). Meanwhile, the euro remains above parity with the US dollar, despite some recent downward pressure, and sits at around $1.05.

For all the positive news, the rush to European assets could be short-lived. A period of consolidation now seems inevitable over the rest of 2025. Longer term, a refashioned new world order, and Europe’s place in it, is a chance for continental renewal. One that could encourage a more sustainable outperformance for the bloc’s markets. 

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