Since the beginning of the year, the benchmark MSCI Europe Index has gained over 12 per cent, significantly outperforming the MSCI World Index’s 3.2 per cent year to date return and S&P 500’s roughly 0.3 per cent loss as of Friday afternoon.
According to Morgan Stanley, this marks Europe’s strongest relative start to a year since 2000 and signifies a stark contrast to its lacklustre past decade.
In a recent market note, Morgan Stanley said sceptics of this outperformance might attribute these gains to investors rebalancing their portfolios towards more value-oriented areas of the market.
But the financial giant said: “While Morgan Stanley’s Global Investment Committee doesn’t yet see a sustainable bull market at hand, there do seem to be some fundamental catalysts behind Europe’s resurgence that bear watching.”
One of these catalysts, it noted, is the economic stimulus likely to stem from the European Union (EU) and the North Atlantic Treaty Organisation (NATO) bolstering defence spending commitments.
In conversation with InvestorDaily, Betashares investment strategist Tom Wickenden confirmed that defence stocks are one of the segments the fund manager is positive on within the region, with countries already ramping up their defence budgets.
“The US administration has made it clear that it is no longer a given they will support Europe’s defence, at least not to the same extent they have historically,” Wickenden said.
Namely, NATO’s goal of achieving 2 per cent of gross domestic product (GDP) in military spending, set in 2014, has seen significant progress recently. As of June last year, 23 NATO allies were projected to reach the 2 per cent target in 2024.
But President Donald Trump, who in his first term in office made a point to criticise a number of NATO members for failing to meet the threshold, has since asked all NATO nations to increase defence spending to 5 per cent of GDP.
“It was only at 2 per cent, and most nations didn’t pay until I came along; I insisted that they pay, and they did – because the United States was really paying the difference at that time, and it’s – it was unfair to the United States. But many, many things have been unfair for many years to the United States,” Trump said at the World Economic Forum in January.
In response, the British Prime Minister Keir Starmer confirmed his government will spend an extra US$26 billion a year on defence, boosting spend to 2.5 per cent of GDP with an ambition to reach 3 per cent in the next Parliament. Denmark also announced it will utilise an “acceleration fund” to increase spending by US$17 billion.
And, most significantly, the leader of the recently elected Conservatives in Germany, Friedrich Merz, stated Europe must prepare to defend itself without the US and laid out plans to add US$210 billion to Germany’s special defence fund.
Now, Betashares expects NATO to increase the defence spending target from 2 per cent to 3.5 per cent of GDP, or an additional US$250 billion per year.
“For context, the US hyperscaler’s capital expenditure in 2024 was US$219 billion. Defence companies could see comparable increases in demand as AI infrastructure has,” Wickenden added.
But as a whole, the fund manager feels that other areas of the European equity market could disappoint in the medium term.
“In particular, we have fears for areas that will likely be most affected by President Trump’s tariffs, like automotives.
“We are also closely watching areas of the market that are benefiting from expectations of much lower energy costs and significant infrastructure spending in the immediate aftermath of any peace deal between Russia and Ukraine. Lofty expectations about these outcomes may not eventuate to the extent the market expects,” Wickenden said.
Regarding financials, the investment strategist said this segment of the market experienced solid earnings beats in the recent reporting season and, like its US counterpart, is benefiting from a strong rebound in capital market activity.
However, Betashares is favouring European financials whose profits are more exposed to investment banking as opposed to deposit franchises.
“The sector also remains trading at around a 40 per cent discount to the broader market. This is another example of how investors could get exposure to Europe in a tactical manner rather than buying the whole market,” Wickenden said.
BlackRock, too, has upgraded European stocks from “underweight” to “neutral” as European equity gains have continued to outpace US markets since the start of the year.
According to the financial services firm, European companies required a catalyst to reverse the negative sentiment surrounding them.
“We now see several that – if they materialise – could boost cheap valuations, so we close our underweight on Europe’s stocks,” BlackRock said in a market update.
“We eye other catalysts for European equities as well. We expect more defense spending as the US has stated Europe is no longer a primary security priority. The EU now has an air of urgency that typically spurs action.
“So, we go neutral Europe’s stocks and still favour European financials – a preference that also served us well last year. Yet Europe still faces multiple structural issues, from lagging competitiveness to potential US tariffs – justifying some of Europe’s hefty valuation discount, we think.”
Uncertainties remain
Russel Chesler, head of investments and capital markets at VanEck, told InvestorDaily that with US growth moderating, regions like Europe are generally looking more attractive.
“The first two months of 2025 have seen a near-complete reversal in market leadership from last year, with European and Asian stocks outperforming, while US equities, though still attracting flows, are no longer the clear standout,” Chesler said.
“Earnings growth outside the US is accelerating, particularly in Europe, where companies have posted stronger revisions.”
But while Europe presents a compelling opportunity, the investment lead warned that geopolitical tensions remain a “significant overhang” for its equities.
“We believe more time is needed before investors commit to long-term positions in Europe as market uncertainties persist.”
Marc Jocum, senior product and investment strategist at Global X, agreed that structural challenges, fiscal pressures and global uncertainties could limit further upside for European markets.
“Additionally, with markets already pricing in a Russia–Ukraine peace deal, the upside is limited if it happens but there’s clear downside risk if it falls through,” Jocum said in a recent market note.
The same factors that could provide headwinds for defence stocks in the region – the likes of the US’ shifting stance on Europe and NATO – may also introduce new layers of instability, Jocum warned.
