Key Takeaways
- Although tariff turmoil cannot be underestimated, the changing global situation means that Europe – set for an injection of €500 billion as a result of Germany relaxing its spending rule – is a compelling investment opportunity.
- Despite this, some sectors will continue to struggle, so broad exposure is not the right approach. The key is finding the ‘diamonds in the rough,’ so stock selection is vital.
- We believe high-quality companies with strong pricing power, durable competitive advantages, and the ability to generate sustainable cash flows will not only benefit from European macroeconomic shifts, but also compete globally and outperform over the long run.
European equities have spent the past decade in the shadow of the US, with investors favouring the dynamism of American technology stocks. Now, however, in a world where long-held assumptions are being regularly challenged, we believe a shift is occurring. Europe presents a more compelling investment opportunity – one that is based on its own merits, not just as a reaction to US market troubles. Our conviction in Europe stands amid the threat of US tariffs, which only directly affect exporters to the US and where the main target is China.
Europe: the current opportunity
European stocks are unloved, under-owned and undervalued – and relative to their US counterparts have been underperforming. But there is a constant appetite for Europe, particularly among domestic European investors. Although challenges in the US – tariffs, political instability, and stretched valuations – might be enough reason to make diversification attractive, there are an additional set of catalysts around Europe that could help drive a sustained equity rally.
Germany’s decision to relax the debt brake presents a major turning point. The brake was a constitutional fiscal rule that limited government borrowing to 0.35% of GDP, which of course limited capital expenditure. As a result of this rule, Germany has debt levels far below those of other European economies (around 62% of GDP compared to 111% in France, 97% in the UK and 135% in Italy, for example). The likely incoming chancellor, Friedrich Mertz, has pushed through two exemptions to the brake: a €500 billion special infrastructure fund, and defence spending of more than 1% of GDP to be excluded from the brake.
This is not a marginal adjustment; it is a major structural shift, in a country that historically was the most fiscally conservative in Europe. A significant amount of capital expenditure is going to flood the European economy and could pave the way for similar moves across the continent, creating a more supportive investment climate for years to come.
Crucially, this spending will target sectors poised to benefit from Europe’s evolving economic landscape. Defence stocks, infrastructure companies, and industrial companies exposed to German projects stand to gain significantly, while broader market sentiment is already rebounding.
Monetary policy is another tailwind. Although there could be some theoretical interest rate risk in the long term because of defence and government expenditure, German public finances are not stretched. So this is less of an issue than in other European countries. In Europe there is greater room for monetary easing compared to the US – European rates could fall below 1.5% by the end of 2025, down from 2.5% currently. This would support European equities, particularly in interest rate-sensitive sectors like banking and real estate.
Globally, a dominant theme is tariffs, and Europe is not immune. However, there are two potential limits on the damage they will do to Europe. One factor is that to be subject to tariffs a country has to manufacture a product and export it to the US. While autos, spirits, and some elements of luxury will be hit, there are many businesses in Europe that sell services or technology and are not manufacturers. These service segments will be protected from tariffs.
A second important factor is that tariffs in many ways hurt US companies more than European ones. President Trump’s agenda is not simply to exclude Europe (and others) from the US; it is to force a reappraisal of the way US companies conduct business. The goal is to end offshoring and bring industry and production back to the US from cheaper locations such as Mexico, Vietnam, and Africa. That is very different from a blanket dislike of Europe, which is seeing a much more modest proposed tariff penalty.
Europe is home to several industries that are structurally well-positioned. Luxury goods, for instance, continue to demonstrate strong pricing power. Even in the face of tariffs, certain high-end European brands are irreplaceable. If a consumer has a strong interest in a top-tier leather handbag, for example, there are few US-made choices. Meanwhile, European industrials, software and other technology firms benefit from secular growth coming from automation, artificial intelligence, and the digitalisation of industry.
Stock selection is vital
While Europe looks attractive overall, broad exposure to the market is not the best strategy. Certain sectors will face headwinds for years. European auto manufacturers were beleaguered even before tariffs arrived, with supply chain challenges and a business model disrupted by the shift to electric vehicles (China has cheaper and better technology). Simply buying a European equity ETF would leave investors with heavy exposure to these struggling industries.
This is why active stock selection is critical. The key is identifying the ‘diamonds in the rough’ – companies insulated from the macroeconomic risks (tariffs) and positioned to capitalise on European tailwinds (the relaxation of the debt brake).
An excellent example is the German software giant SAP, which now has a larger market capitalisation than the entire German auto sector. This reflects the growing importance of technology and digital infrastructure relative to traditional manufacturing. Investors who buy into an ETF or index giving exposure to the whole spread of the German market are saddled with underperforming auto stocks and heavy industrials, but those who focus on quality and future-oriented business models can capture significant and unencumbered upside.
Stock selection is crucial in the banking sector. European banks, particularly those in southern Europe, have seen a strong recovery over the past decade, driven by improving balance sheets and greater capital discipline. However, the best investment opportunities lie in well-capitalised banks with strong business models, not just those that benefitted from rising rates. Selectivity is critical to avoiding underperforming institutions while capturing upside in well-positioned financial firms.
Quality matters
Ultimately, we do not invest in economies, we invest in businesses. And the best determinant of a company’s success is its business model, its ability to leverage macroeconomic trends, and its resilience. That is why quality is such a critical factor in investing in Europe.
High-quality companies have strong pricing power, durable competitive advantages, and the ability to generate sustainable cash flows. In Europe, these are often found in the luxury sector, in specialised industrials, and in select technology firms. These businesses are not only positioned to benefit from European macroeconomic shifts, but also can compete globally.
Quality is about resilience. Economic cycles boost short-term volatility, but companies with strong positioning, a good management team, and disciplined capital allocation will, we believe, outperform over the long run. The recent performance of European equities, where the gains have narrowed, reinforces the importance of being selective. A broad-brush approach will not capture the best in Europe.
The bottom line
The case for European equities is stronger than for years, but success requires more than just recognising the opportunity. Although Europe’s valuation discount and the potential for fiscal stimulus and monetary easing provides a supportive backdrop, not all will benefit. The key is to focus on high-quality businesses with strong pricing power, resilient business models, and the ability to capitalise on European and global trends. Active stock selection provides the best path to capture this potential.
