After years of "American exceptionalism," European stocks are outperforming US equities, fueled by investor interest and significant fund inflows. This article explores whether this trend signals a long-term shift or a temporary relief rally, considering factors like German fiscal stimulus and EU reforms.
Remember the narrative of American exceptionalism, where the US market and its tech giants were the only game in town? Well, the tables seem to be turning. Since Donald Trump's election, European stocks have outperformed their US counterparts, catching many by surprise.
This shift has sparked genuine investor interest, with analysts reporting a surge in questions about European markets.
The renewed interest in European equities is evident in the fund flow data. In the week leading up to March 5, Western European equity funds saw an inflow of $4 billion, marking the highest in three years. Year-to-date inflows have exceeded $10 billion, a stark contrast to the prevailing investor sentiment of the past decade.
While these figures may seem modest compared to the massive sums flowing in and out of US equity funds, they represent a significant shift in investor attitude towards Europe. Western European equity funds have experienced inflows for four consecutive weeks, the longest streak since the stock market mania of mid-2021.
The question now is whether this European resurgence is sustainable. Europe's economic performance has often been described as promising yet ultimately disappointing, struggling to secure major wins since 2008. However, there are signs of a potential fundamental shift in market sentiment.
Barclays' European equity team suggests that the recent outperformance of European stock markets is primarily a "relief rally." According to Barclays, systematic investors closed their short positions on Europe after realizing that the impact of tariffs might not be as severe as initially feared. Hopes for a ceasefire in Ukraine and positive EPS revisions due to a weak FX rate also boosted sentiment.
This led P/E multiples in the region to climb back to just above fair value levels, and unwind the Trump risk premium that built up after the US election.
However, real money investors remain skeptical about the extent of Europe's catch-up, given the region's still-weak growth backdrop. Inflows year-to-date have not fully compensated for the redemptions seen in Q4 of the previous year.
The key to a more sustained recovery may lie in Germany's recent fiscal initiatives.
A fiscal bazooka from Germany this week and news flow of reforms at the EU-wide level could be a regime change and mark the advent of Europe 2.0.
This is reflected in the synchronized surge in equities, bond yields, and EURUSD. Germany's proposals include a EUR500 billion fund for infrastructure spending and reforms to the debt brake limits, in addition to significantly higher defense spending.
Monetary policy remains supportive, with the ECB recently lowering rates by 25bps. However, reflationary fiscal policy may reduce the likelihood of further easing.
If Draghi's proposals and other pro-growth/supply policy measures materialize, they could reignite domestic growth in Europe and Germany, which has been missing since the Global Financial Crisis (GFC).
Eventually this could lift growth in Europe above trend, leading investors to strategically rebalance their allocations more towards the region and drive valuations above average.
This is a scenario that many are not yet positioned for, as the prevailing playbook for the past two decades has been US exceptionalism.