European Equities Poised for Revival as Fiscal Stimulus and Valuations Attract Capital

European stock markets are entering 2026 with renewed momentum, as the STOXX Europe 600 Index trades near record highs and strategists forecast double-digit gains driven by fiscal stimulus, attractive valuations and a fundamental shift in capital allocation.

After outpacing the S&P 500 in early 2025 before falling back, European equities are now attracting fresh institutional interest following nearly a decade of US dominance. The question facing investors is whether this marks a temporary rotation or the beginning of a sustained reallocation that could see €1.2 trillion shift from American to European markets over the next five years.

Valuation Gap Creates Opportunity

The investment case begins with arithmetic. European equities trade at 14.8 times forward earnings—above their long-term average but still at a significant discount to US markets when adjusted for sector composition. European banks trade at 9 to 10 times price-to-earnings ratios compared with their American counterparts, while industrials command valuations that reflect years of scepticism about the continent’s economic growth prospects.

What has changed is the outlook. Germany’s €500 billion infrastructure programme is beginning to flow through supply chains, defence spending is ramping up across the continent, and the European Central Bank has cut benchmark rates in half to 2 per cent since mid-2024. Europe is attempting to shift from an austerity mindset to a growth mindset, creating reflationary pressure that could support corporate earnings after 55 consecutive weeks of downgrades.

Infrastructure and Defence Lead Sector Rotation

European utilities have emerged as unexpected beneficiaries of the artificial intelligence boom. With the highest capital expenditure of any sector as they invest in energy transition infrastructure, utilities are signing long-term power purchase agreements with data centre operators. Surging demand for power driven by AI has provided visibility on returns that investors previously questioned, pushing the sector to outperform broader indices.

European banks continue to attract capital despite becoming a crowded trade. The sector benefits from improved net interest margins, stronger balance sheets than at any point since the financial crisis, and dividend yields that look attractive in a lower-rate environment. Financials and industrials—the two largest sector weights in European indices—are forecast to deliver the highest earnings growth in 2026.

Defence contractors represent perhaps the most dramatic transformation. Once considered politically sensitive investments with uncertain order books, they are now being priced as strategic infrastructure companies with multi-year revenue visibility. The sector is benefiting from hundreds of billions of euros in committed spending as European nations rebuild military capabilities.

Materials companies exposed to infrastructure spending and select pharmaceuticals with strong pipelines complete the opportunity set for investors positioning ahead of fiscal impulse.

Currency and Execution Risks Temper Enthusiasm

The euro’s 7 per cent appreciation against the dollar weighs on earnings for large-cap exporters while making European stocks more expensive for American investors. This currency dynamic explains why domestic-focused companies are attracting more interest than the export-heavy industrials that have traditionally defined European equity indices.

Execution risk around fiscal programmes remains material. Germany’s infrastructure spending has been slower to deploy than markets anticipated, dampening the initial enthusiasm that drove outperformance in early 2025. Political fragmentation across the continent adds uncertainty, though French markets have stabilised after months of turbulence.

Earnings forecasts tell a sobering story. Consensus expects European earnings to decline marginally in 2025 before posting modest single-digit growth in 2026—far from the robust expansion that would justify significant multiple expansion. The bull case depends on fiscal programmes delivering tangible economic acceleration in the second half of the year.

China Exposure and Institutional Flows

European equities carry significant sensitivity to Chinese economic conditions through luxury goods, automotive and industrial sectors. Recent policy developments in Beijing could provide tailwinds, particularly for luxury brands deriving substantial revenues from Chinese consumers. However, this creates asymmetric risk if China’s economy slows more sharply than expected.

The most significant development may be institutional behaviour. After years of outflows, European equity funds are seeing renewed inflows from both domestic and international investors. Portfolio managers estimate €1.2 trillion could rotate from US to European markets over the next five years—representing 6 to 8 per cent of Europe’s equity market capitalisation—as institutions review strategic allocations in response to valuation gaps and diversification needs.

Investors are suffering from recession fatigue after a string of scares in recent years, keeping spreads tight and valuations contained even as fundamental conditions improve. This creates asymmetric opportunity for those willing to position ahead of consensus.

Whether 2026 marks a turning point or another false dawn for European equities will depend on fiscal programmes translating into economic acceleration. For now, the combination of attractive valuations, improving policy support, and cautious positioning suggests the risk-reward has shifted in favour of selective exposure to Europe’s equity markets.

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