European Renaissance

A broadening of equity market performance beyond U.S. mega-caps was one of our key themes for 2025—right now, Europe is where it is playing out most notably.

For at least since the Covid-19 pandemic, many investors have regarded U.S. mega-cap equities as the only game in town.

That sentiment was apparently buried last week. After sputtering and slowing through February, the largest names in the S&P 500 Index started rolling back down the hill.

The rebalancing and broadening of market performance that we anticipated in our Solving for 2025 and our first-quarter Asset Allocation Committee Outlook appears to be underway.

Growth and Tariff Scares

That said, things haven’t gone entirely as we expected.

We thought U.S. value would outperform growth stocks, and they have, by almost nine percentage points since the start of the year. We said Financials and Industrials might close the performance gap with Technology, and they have, also by around nine percentage points. The Nasdaq Composite Index fell 4% in a single day at the start of last week, and the “Magnificent Seven” stocks have fallen into a bear market from their peak on December 17. Meanwhile, the other 493 companies in the S&P 500 have held up well: The S&P 500 Equal Weighted Index leads the Magnificent Seven by 10 percentage points so far this year.

However, we also favored U.S. small and midcaps as likely beneficiaries of above-trend economic growth and a revival of animal spirits, and that has not played out as expected, as the S&P Small Cap 600 Index is down almost 11% this year, five percentage points behind the S&P 500.

We think this is due to the current growth and tariff scares stalking the U.S. economy. Small caps are especially sensitive to growth expectations and, while their businesses tend to be domestically oriented, they typically also have tight margins that can be squeezed by the higher input costs imposed by tariffs. We saw the same pressures push high yield credit spreads wider last week, arguably an overdue move.

The U.S. government’s rhetoric about incurring short-term pain for long-term gain raises recession concerns and weighs on business and market sentiment. We do not think the U.S. is heading that way, but a lot of wind has been taken out of its sails.

Epochal

U.S. travails bring us to the place where broadening performance has occurred sooner than we expected: non-U.S. markets.

Japan equities remain marginally ahead of U.S. stocks so far this year. But China’s CSI 300 Index is now more than nine percentage points ahead of the S&P 500, and the STOXX Europe 600 Index has raced ahead by an extraordinary 13 percentage points.

We need to see continued repatriation of capital by domestic investors to be confident in renewed momentum for Japan; and China’s recent measures signaling a tilt back in favor of the consumer and the private sector remain just a promising start, for now. By contrast, Europe’s fiscal spending plans already look potentially epochal.

Concentrated Minds

These changes center on Germany. Tomorrow, incoming Chancellor Friedrich Merz is set to use a majority in the outgoing legislature to pass amendments to the country’s constitutional “debt brake” that would exempt most defense spending from its rules and allow the creation of a €500 billion infrastructure fund.

But Germany has also thrown its weight behind a reform of tight fiscal rules at the eurozone level. At the same time, European Union leaders have endorsed the European Commission’s proposal that defense spending should be temporarily exempted from those rules, and for a €150 billion fund for defense loans to Member States. Common European defense bonds and the European Union acting as a central weapons-purchasing body are among other notable ideas on the table.

Back in January, we said we would become more positive on non-U.S. markets if we saw “fiscal loosening as a result of political realignments in France and Germany, or a peace-and-reconstruction deal for Ukraine.” All three were possible, we wrote, but we thought stimulus from France would be small, stimulus from Germany would be a story for the second half of 2025, and a Ukraine settlement was “speculative.” In the event, the new U.S. administration’s ambivalence toward the North Atlantic alliance has concentrated minds to an extent almost unthinkable eight weeks ago.

So far, in keeping with the broader trend we identified last month, investors appear to be looking past the inflationary potential of this spending and pricing it with a “growth mindset.”

The euro has strengthened rapidly against the U.S. dollar, while the yield differential between German and U.S. government bonds has closed by some 80 basis points so far this year and the European Central Bank’s tone has turned cautious. But the German yield curve has steepened rather than flattened, and any jolts to European equities have come from U.S. tariff threats rather than concerns about rising inflation or rates.

Volatile Times Ahead

What could curtail Europe’s renaissance?

One possibility is a reversal of market sentiment. The current performance may be attributable to the new enthusiasm for spending and unified defense efforts. Then again, it could simply be the result of a rotation out of the U.S. market, or out of highly valued assets in general. Note that it predates the German election and Merz’s conversion to fiscal generosity, and has been quite broad-based rather than concentrated in defense stocks.

If Europe’s moment is just a symptom of the general collapse of the momentum factor—which has seen some cheap cyclical stocks do well despite being in the U.S., and some overbought quality staple stocks do poorly despite being defensive—its fundamentals may not protect it from a return to momentum. This is a reminder to maintain diversification in market factors as well as asset classes, regions and sectors.

Another possibility is that the occasional jolts from tariff threats become a generalized global sell-off, as the immediate threats to growth in Europe overwhelm the longer-term potential of the stimulus. The U.S. imposition of tariffs on European steel and aluminum last week and the prospect of broader reciprocal tariffs after April 2 increase this risk, in our view.

Hard and volatile times may be ahead, but European markets have bounced back faster and stronger than we could have imagined at the start of this year. Even so, the latest Bank of America Global Fund Manager Survey suggests that, while investors are trimming U.S. exposure, they are still overweight. No one should expect the STOXX Europe 600 to repeat the 10-week streak of unbroken gains with which it opened the year, but we would not rule out more European outperformance to come.