The year of European outperformance?

The European STOXX 600 index outperformed the S&P 500 by approximately 7% in USD terms in February. The contrast is stark compared to last year, where the S&P 500 outperformed European equities by 23%. 

The German elections further bolstered positive market sentiment, aligning with expectations of a potential coalition between centre-right parties (CDU/CSU and SPD). However, the emergence of a blocking minority formed by the far-right (AfD) and the left (Linke) could hinder reforms. 

Optimism and vulnerabilities 

The specifics of the Russia-Ukraine ceasefire will be pivotal in shaping the performance outlook. A ceasefire with robust guarantees could act as a positive catalyst for Europe, potentially extending its outperformance. This scenario might lead to declining gas prices and stimulate growth in the industrials and materials sectors, particularly as Europe prepares for Ukraine's reconstruction. While reconstruction efforts are expected to boost GDP growth, these benefits are unlikely to materialise before 2026. 

Despite the recent strong performance of European assets, risks remain. Potential Trump tariffs targeting the region, coupled with a persistent earnings growth gap favouring the US, could undermine Europe’s outperformance and shift momentum back to US markets.

Increase in defence spending 

The potential resolution of the war has prompted discussions on increasing defence spending across Europe, with projections of fiscal spending rising from 2% of GDP to 2.5-3% of GDP. If each country funds the increase individually, nations with high debt levels, particularly in Southern Europe, would face challenges. Such an approach could significantly raise deficits and lead to sizeable increases in bond yields. 

Alternatively, funding at the EU level, either through a dedicated recovery fund for defence spending or by redirecting unspent Covid-19 support funds, presents another option. Issuance of bonds at the EU level, based on previous experiences, has not triggered major adverse effects, maintaining protection against bond downgrades and avoiding market disruption. 

Germany raises deficit allowance 

Recently, Germany announced that leaders of the CDU/CSU and SPD agreed to a EUR 500bn off-budget infrastructure fund, to exempt defence spending from debt brake limits (exceeding 1% of GDP), and raised the structural deficit allowance for states to 0.35% of GDP. 

European bond yields have increased on the back of this higher government spending, alongside the euro strengthening. The domestic German market responded positively reflecting the optimism of the industrial sector. While defence spending may have a limited growth multiplier, as much of it will fund arms purchases abroad, infrastructure investment could provide a stronger cyclical boost to the economy starting in 2026. A key factor to monitor is whether these developments will bolster German consumer confidence and increase consumption. 

Amidst these developments, European markets remain influenced by a variety of factors. A ceasefire with guarantees of peace would provide a strong positive signal, offering a chance to reevaluate increased allocations to European equities.