By Reshma Kapadia

European stocks have trounced the S&P 500 index this year, grabbing the attention of investors seeking to diversify as the Trump administration upends long-held assumptions about security and economic alliances.

The STOXX Europe 600 is up 8% while the S&P 500 is down 3% so far this year, the biggest outperformance in more than two decades. It's an about-face in a market that has been sitting in the bargain bin for years as the war in Ukraine and anemic economic growth made it an unappealing alternative to a booming U.S. economy and market.

The swiftness of the recent move in European stocks could set the stage for a short-term pullback, especially if President Donald Trump follows through on some of his more- aggressive tariff threats. But many investors see a pullback as a chance to buy into an underowned part of the world that is in the early phases of a political and economic sea change.

It doesn't take much to ignite a cheap market. Even after the run-up, the STOXX Europe 600 is trading at 14.6 times 2025 earnings, compared with the S&P 500 trading at 21 times. The sparks came from the White House clash with Ukrainian President Volodymyr Zelensky and the interim suspension of aid to Ukraine in its war with Russia, a flurry of tariff threats, and comments from Trump administration officials that threw into question America's security commitments to Europe.

Within weeks, Germany loosened a "debt brake" put in after the global financial crisis, and parliament passed a one trillion euro ($1.08 trillion) infrastructure and military spending package. The European Council approved a proposal to exclude military spending from its fiscal rules and created a EUR150 billion loan facility to fund military spending.

"The U.K. and France said they would step up their security and nuclear capabilities, and Germany decided to abolish what was its self-imposed fiscal straitjacket," says Juhi Dhawan, macro strategist for Wellington Management. "Investors are realizing that perhaps we are going to see a source of growth come from a region that hasn't had any in a long time."

But it isn't clear sailing: The Trump administration is expected to unveil plans for more tariffs to equalize trade and possibly industry sector-oriented tariffs of as much as 25%. Still unclear is what will materialize -- and how long it will stick, with Trump on Monday saying he planned to give some countries a break. That said, an escalation in the trade battle could hit global growth. That would be a problem for Europe, especially countries such as Germany with big industrial bases tied to exports.

Europe's plans for increased fiscal stimulus could offer a buffer. An additional boost would come if Russia and Ukraine reach a full cease-fire, with such a deal potentially easing gas prices and creating an opportunity to rebuild Ukraine. Plus, China's stimulus plans to boost its recovery could help European companies that generate roughly 10% of sales from that economic powerhouse.

Accelerating Growth

Deutsche Bank's strategists expect Germany's real gross-domestic-product growth to accelerate to 1.5% next year and 2% in 2027. Others see about a 0.5 to one percentage point increase to GDP over the next five years from the fiscal spending plans.

These changes come as green shoots were already beginning to emerge as the European Central Bank's 1.5 percentage point cuts in interest rates since last summer begin to bear fruit. Bank lending to households is picking up, fueling home purchases that should boost construction. Manufacturing activity in Germany is also percolating after a two-year downturn, and feeding into improving earnings and economic growth in Europe just as the U.S. loses steam, says Jeff Morrison, an institutional portfolio manager for the MFS Blended Research International Equity fund.

European stocks have been cheap for years, but Morrison says they now have catalysts to move higher. He sees earnings and price momentum in more-cyclical areas of the market, including financials, industrials, technology, and energy. Another positive: Recently elected governments are talking about deregulation. United Kingdom Prime Minister Keir Starmer, for example, wants to cut red tape and use artificial intelligence and other technologies to boost efficiency and reduce costs.

Gavekal Research's European economist Cedric Gemehl sees the shifts in Europe as "just the beginning." The reason for his optimism: Europe is shaking off the belt-tightening that shaped the region's economy through the 2010s for a possible reflationary period fueled by a willingness to spend. "The missing piece [for a recovery] had been the fiscal regime in Europe," Gemehl says.

Germany's debt-to-GDP ratio has been about 60%, compared with closer to 100% in the U.S. That gives Germany room to bolster spending and give its economy -- and markets -- a bit of the sugar rush enjoyed for years in the U.S., just as the U.S. possibly enters a belt-tightening phase.

"I'm generally very cautious and not a risk-taker," says Piera Elisa Grassi, a manager in J.P. Morgan Asset Management's International Equity Group. "But the economy is moving in the right direction. And aside from Germany, there is a lot of spending that wasn't utilized that could come into play over the next 12 months, offering another support to valuations."

Southern Europe's Comeback

Investors taking their first close look at Europe in years may be surprised to find that the troubled economies of southern Europe that were at the center of the region's 2009-12 sovereign debt crisis are now thriving and leading the improvement in the region's earnings. Across Europe, companies last year bought back more than $200 billion in stock, and earnings are showing signs of improvement.

These trends emerge as investors have largely had eyes for the U.S. An unprecedented $600 billion flooded into U.S. equities and $60 billion out of European equities in the 12-month period through mid-February, according to Inigo Fraser Jenkins, co-head of institutional solutions for AllianceBernstein. Even with the sharp move this year, only $17 billion has flowed into Europe in the past month as flows to U.S. stocks have slowed to $45 billion. That could be a sign that investors are early in their bid to take some of their chips off the U.S. table and reallocate them to Europe.

"There's a transition under way to a more orthodoxy-oriented administration, and that shift has made investors a bit nervous," says Ben Ritchie, head of developed markets equities for London-based Aberdeen Investments, about the Trump administration's focus on deficits and emphasis on bringing capital back to the U.S. "That creates a lot of friction," making Europe look more favorable.

Still, Ritchie and other strategists say the gains so far this year suggest that the European market could be in for a pullback -- and that investors should be selective in buying on the dips rather than chasing the military-industry stocks that have soared.

Matthew Gilman, head of Europe equities strategies at UBS Global Wealth Management, favors small and midsize companies, including industrials, utilities, European information technology, and real estate. These companies still trade at their cheapest point versus large-caps in 20 years, and they often are more domestically oriented and somewhat insulated from tariffs, Gilman adds. Ways to invest in European companies include two exchange-traded funds: the iShares Core MSCI Europe for broad-based exposure and the iShares MSCI Europe Small-Cap to tap into small and midsize companies.

Smaller is Better

Thomas Shrager, co-manager of the Tweedy Browne Value fund, owns military companies Safran and BAE Systems that have run up this year, but he is finding more value in smaller companies like French chemical maker Arkema that have been hit amid an industry downturn. Arkema sells to construction companies, which could get a boost from increased fiscal spending. The company's growth should improve as it reaps the benefits of capital spending projects and recent acquisitions as the industry recovers. Another holding is Finnish water chemical company Kemira, which has a pristine balance sheet. It also has a cost advantage versus European rivals, sourcing electricity to run the business with its minority stakes in nuclear and hydro plants. After a flat year for Kemira, Shrager sees improved pricing and cost cuts helping growth recover in a stock that trades at 12 times earnings and 70% of its intrinsic value.

Shrager also sees value in Porsche even as autos are in the tariff crosshairs. "The guy who spends money on a Porsche doesn't care if it's $220,000 or $200,000. Tariffs will impact more mass-market exporters, so we don't own the obvious cheap ones like Volkswagen or even BMW, which is becoming more mass market," he says. Trading at 14.5 times earnings, Porsche is more expensive than these auto makers, but for Shrager, it is still "cheap enough."

Even after the run-up in the European market, Kimball Brooker, co-head of First Eagle's Global Value Team, says that there are wide disparities between valuations in the region and the U.S. He puts British American Tobacco in the cheap bucket. BAT owns about 25% of Indian conglomerate ITC -- home to snack and hotel businesses, as well as a tobacco monopoly in the world's most populous country. While BAT is slower in its transition to noncombustible tobacco than rival Philip Morris International, it has a hefty 7.5% dividend yield and trades at just 8.8 times earnings, compared with 22 times for the U.S. company.

Another company that Brooker thinks has been underappreciated is Belgian conglomerate Groupe Bruxelles Lambert, which owns stakes in spirits company Pernod Ricard as well as Swiss testing and inspections giant SGS. Groupe Bruxelles Lambert trades at a 40% discount to the estimated sum of its parts, according to Brooker. The conglomerate pays a dividend yield of 7%.

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March 27, 2025 00:00 ET (04:00 GMT)

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