Markets Weekly: Europe's Moment?

After years of US market dominance, a remarkable shift is underway. Since the start of 2025, European equities have outpaced their American counterparts, raising the possibility that the era of "US exceptionalism" may be drawing to a close. Germany's DAX has surged over 14% year-to-date, while the STOXX 600 index has climbed around 7%. By contrast, the S&P 500 has slumped by 4.6%, notably lagging behind major global indices.

What’s driving this outperformance in European markets? A combination of political, monetary, and geopolitical factors are creating a tailwind for European stocks.

What’s Driving Europe’s Performance?

• Pro-Growth German Government: Germany’s recent election has reshuffled the political deck in ways that investors are embracing. The newly elected government has prioritized pro-growth policies, including infrastructure spending, tax reforms, and regulatory easing. These measures have bolstered investor confidence, with markets responding positively to the prospects of a more competitive German economy.
• Monetary Policy: The European Central Bank (ECB) has also played an important role. Its signals of further rate cuts have provided an additional boost to markets, creating a more favorable monetary environment for equities.
• Geopolitical Tensions: Another key driver is the surge in European defense stocks. Amid rising geopolitical tensions, Europe has ramped up its defense spending, benefiting companies like Rheinmetall, a leading military equipment manufacturer. This trend reflects Europe’s growing urgency to build its own defense capabilities, which is shaping investor sentiment in the sector.

Macron's Vision

Europe’s market resurgence raises a question: how sustainable is this momentum? The answer may depend on which vision of Europe ultimately prevails. On one hand, French President Emmanuel Macron has emerged as a leading advocate for deeper European integration. His vision emphasizes fiscal unity, a stronger European defense, and enhanced "strategic autonomy."

Macron has made his stance clear last year:

We must produce more, we must produce faster, and we must produce as Europeans... There is a risk our Europe could die. We are not equipped to face the risks.

Macron's vision for a "More Europe" approach aligns with recent EU-level commitments to defense financing. The European Commission is preparing to launch a new instrument to borrow up to €150 billion to fund joint investments in air and missile defense, drones, and anti-drone systems. Additionally, EU President Ursula Von der Leyen has pointed to €650 billion in lending capacity available for defense initiatives, signaling the bloc's readiness to back its ambitions with substantial financial resources.

If Macron’s vision gains traction, the implications for European markets will be significant. Greater fiscal integration, for instance, would likely improve confidence in peripheral European sovereign bonds — those issued by countries like Italy, Spain, and Portugal. These bonds currently trade at higher yields (lower prices) than those of "core" nations like Germany, reflecting higher perceived default risks. Deeper integration could narrow these yield spreads, boosting bond prices and benefiting the balance sheets of banks that hold large amounts of this debt.

Germany’s Pragmatism

On the other hand, Germany’s priorities appear to diverge from Macron’s, particularly when it comes to its economic relationship with Russia. For industrial Germany, the main goal seems to be a return to a constructive relationship with Russia, a key supplier of essential commodities and an important export market. The Ukraine War has disrupted this dynamic, creating a dual challenge for German industry: rising energy costs and lost market access.

As Bloomberg recently reported:

Europe has spent three painful years weaning itself off gas from the east with the biggest impact felt in Germany, the region’s largest economy. German industry was built on cheap Russian gas, and rising energy prices have already trammeled growth and forced some manufacturers to move production abroad.

For Christof Günther, head of one of the biggest chemical industrial sites in Germany, the only way to revive sectors like his is to get hold of cheap Russian gas again. "If Europe is expected to help finance Ukraine’s recovery in future, Germany needs to be economically strong to contribute," he said in an interview in Leuna.

This pragmatic approach to economic policy could have ripple effects on European markets, particularly in the defense sector. Macron’s push for European defense sovereignty has driven joint R&D and procurement programs, benefiting Europe-based arms manufacturers. However, if Germany prioritizes economic re-engagement with Russia, leading to reduced geopolitical tensions, investors may anticipate a decline in defense spending, especially for Europe-based initiatives.

Unified Europe For Now

For the time being, the vision of a more unified Europe remains the dominant narrative. Much of this is fueled by external pressures, particularly from the new US administration under Trump, which has placed immense pressure on Europe to step up its defense efforts. This geopolitical backdrop is likely to sustain market enthusiasm for European defense stocks in the near term.

Nevertheless, Europe’s long-term trajectory remains uncertain, hinging on the balance between competing priorities: Macron’s push for greater integration and strategic autonomy versus Germany’s pragmatic focus on economic recovery and stability. Adding to the uncertainty is the wild card of US policy under the new administration. For now, markets will be watching closely to see which policy direction ultimately prevails.

Long / Short

Fixed Income: "Long-term US Treasuries have rallied as recession fears grip markets. Yet they don’t reliably buffer against equity selloffs given persistent inflation. And yields could spike suddenly. One reason: Higher-for-longer Fed policy rates and persistently large fiscal deficits – even with tariff revenue and spending cuts – could push investors to demand more compensation for the risk of holding long-term bonds. We stay underweight long-term Treasuries, preferring short-term notes for income." (Blackrock)

Euro Area: "The medium-term growth outlook in the Euro area has improved on the back of the potentially dramatic change in German fiscal policy under incoming Chancellor Friedrich Merz. The preliminary agreement between Merz’s CDU/CSU and its smaller coalition partner SPD entails 1) suspension of the debt brake for defense spending above 1% of GDP, 2) a special infrastructure fund of EUR500bn or 10% of GDP, and 3) a small but politically astute loosening of the debt brake constraint on state and local governments." (Goldman Sachs)

Quick Hits

• Hedge Funds Sell Stocks: Hedge funds embark on stock retreat unseen in years
• Consumer Confidence Plummets: Consumer sentiment slumps in March to the lowest since 2022 as Trump tariffs spark more inflation worries.
• UK Economy Shrinks: The UK economy unexpectedly shrank by 0.1% in January.
• BOJ Weighs Risks: The BOJ is expected to hold rates steady, weighing the risks of Trump's trade war.
• India Braces for Steel Surge: India braces for a steel import surge as Trump's tariffs ripple across the globe.