Fancy a few European defence stocks? Not long ago, the answer to that from pretty much all investors would have been a very firm “no”.
Defence didn’t fit the environmental, social and governance (ESG) metrics of most fund-management firms and Europe was seen as a long-term value trap.
Why buy into low productivity countries with horrible energy policies and dodgy politics if you could buy into American exceptionalism and can’t-go-wrong technology stocks instead? That’s been the right take for some time.
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But around the middle of last year things started to change – and this year the shift is obvious.
Year to date, both the Dax and Cac indices have beaten the S&P 500. The former are up 12% and 9% respectively. The MSCI All Country World index is up 7%. The S&P? Down 1.3%. The Magnificent Seven (the can’t-go-wrong ones) are down over 3%.
European markets have been the best performers globally this year so far (with the UK a close second). That’s the first time that has happened since 2012.
Why are European markets outperforming the US?
So what on earth is going on? You could argue that the world has suddenly noticed two things. First that Europe is cheap, and second that it isn’t a value trap.
The first bit makes sense – particularly if you look at it in the context of US valuations. The US is well over 30% overvalued relative to its 15-year medians on any measure you choose to use – and 56% overvalued relative to dividend yield history, says Schroders’ Duncan Lamont.
Europe (ex UK) is a little overvalued on most measures – its forward price-earnings ratio (p/e) of 15 times is 6% greater than the 15-year median, for example. But even if you think it slightly expensive relative to its own history, it is “still very cheap versus the US”.
That means that there is room in Europe for prices to rise on valuation expansion alone (as they have been this year), something that isn’t really available to the astonishingly overpriced US.
At the same time, buybacks have been on the up since mid-2021 and company earnings forecasts don’t look too bad at all. Lamont notes that 46% of US companies are forecasting double-digit earnings growth over the next 12 months. In Europe that number is 51%.
The second – the idea that not all Europe’s woes are both structural and unfixable – is arguable.
Some things have definitely improved, says BCA Research. The banks across the eurozone look better; much corporate deleveraging is complete; and there are some policy shifts underway.
There is, for example, (finally...) rising recognition that perhaps sometimes you can have too much regulation.
Fiscal austerity also looks to be easing a little.
Take Germany. The election is out of the way and the deliberations between the centrist parties assumed to be forming a coalition have taken what Deutsche Bank call a “surprising turn” – one that “could have more significant ramifications for the fiscal outlook” than the election results initially suggested.
The idea is to ease Germany’s “debt brake” in the last few weeks of the current parliament, “with a view to unlocking future debt funding for defence spending” – something in the region of €200 billion. Real money that would be used to “accelerate the rearmament drive”.
The consequences might not be huge for the domestic defence industry in the short term (it takes a while to expand production facilities), but it would still be “good news for growth in the medium term” and would “signal to the corporate sector a strong resolve to address Germany’s structural challenges”.
What does this mean for the US?
The other way to look at this shift in momentum is not in terms of excitement about Europe but of caution on the US – a sense perhaps of peak exceptionalism.
Might it be that, after an extraordinary decade, one in which the US market was the top global performer in all but two years (2017 and 2022), it is getting dangerous to be quite as exposed as most are to the US?
Perhaps China’s surprise advance in AI represented by DeepSeek has been a reminder to investors that exceptional stuff can happen outside the US too – and one that is making them slowly re-evaluate the wisdom of their lack of diversification.
Either way, US investors in particular have been allocating more and more to European and UK stocks. US investors now own 30% of the UK’s market. That’s up from 19% in 2008. They also hold 29% of Switzerland and 18% of France.
There is an argument that the US market will be protected by some kind of “Trump put” – as Bank of America strategist Michael Hartnett told Bloomberg, “the stockmarket is his traffic light”, so if it falls too much he will intervene fiscally. But US investing guru Jeremy Grantham still expects a major correction in the overvalued US market (timing uncertain!), yet has “no argument”, he tells me on the Merryn Talks Money podcast, with the non-US markets, which are “much less dangerous to own”.
If history follows the usual pattern, they will be “sympathetic” in a major decline in the US market and may drop frighteningly when it happens. But they will regroup faster, “and they will very likely over five or ten years crush the US”. Success in investing is as much about what you avoid as what you buy. Those who don’t want to be crushed might want to start rebalancing.
Merryn is Bloomberg UK Wealth’s editor-at-large, covering personal finance and investment; the author of the Merryn Talks Money newsletter; and host of a podcast of the same name. Sign up at Bloomberg.com.
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