European exceptionalism: A new era for value investing?

European equities have made an exceptional start to 2025 and are ahead of US stocks by a wide margin. Richard Halle, manager of M&G Investments’ European Strategic Value strategy, and Johnny Hughes, Head of Global Equity & Multi Asset Investment Specialists, explore what’s making European markets great again – and ask: Could be the start of an exciting new era for value investing in Europe?

After years of underperformance, European equities are outperforming their US counterparts in 2025. Investors’ new-found enthusiasm for the asset class is a seismic shift, particularly given the extreme amount of pessimism towards Europe at the start of the year.

Concerns about fiscal problems in France and Italy, the ongoing war in Ukraine and the region’s lacklustre economic growth all contributed to the negative sentiment. The pessimism was evident in the money flowing out of European equities and also in valuations. The valuation gap between Europe and the US had reached an extreme level, driven largely by widespread acceptance of the narrative of US exceptionalism and the corresponding notion of European decline.

Europe’s valuation discount to the US has been widening

Source: Refinitiv Datastream, Worldscope, Goldman Sachs Global Investment Research, December 2024. Europe relative to US 12m forward price-to-earnings ratio. 

When investment regimes change and long-running trends reverse, we believe there’s often a ‘blow-off top’ phase, a final period of exuberance. We saw this in the dot-com crash in 2000 and in the run up to the financial crisis in 2007/8. 

President Trump’s election victory in November 2024 was arguably a catalytic event that intensified the prevailing trends widening the valuation gaps even further. But the belief in US exceptionalism may have been misplaced. The huge amount of fiscal stimulus in the US – the federal budget deficit is running above 6% of GDP¹  – was boosting an already strong economy, supporting consumer spending and, in our view, fuelling bubble-like behaviour in some parts of the stock market.

However, this year some of the factors that underpinned US exceptionalism have gone into reverse. Notably, there appears to be a realisation that US government spending is on an unsustainable path – hence DOGE, the Department of Government Efficiency. President Trump’s tariff policies have also sparked fears about an economic slowdown and consumer confidence appears to be weakening. 

Conversely, Trump’s efforts to Make America Great Again appear to be having a galvanising effect on Europe. Motivated by the possibility that the US might reduce its military support for Europe, the incoming German Chancellor Friedrich Merz has announced a huge stimulus package to invest in infrastructure and defence. The easing of the so-called “debt brake” to boost defence spending shows emphatically that Germany is embarking on a new path².

“Trump’s efforts to Make America Great Again appear to be having a galvanising effect on Europe”
 

Combined with the European Union’s proposed €800 billion increase in defence spending, Germany’s stimulus potentially represents a game-changing development for the continent’s prospects³. 

From an investment perspective, we believe this new environment could lead to a new narrative around Europe. The outperformance of European equities this year suggests that investor sentiment has changed; we could well be witnessing the start of a new investment regime.

New regime, new winners

Just as investors have favoured the US over Europe in recent years, within the European market there has been a clear preference for growth over value. Any money that has come into the market has typically been directed towards growth stocks and cheaper, out of favour parts of the market have been overlooked. This has resulted in an extremely wide valuation gap between value and growth stocks, which, in our view, represents a compelling investment opportunity.

In Europe, value trades at a wide discount to growth

Source: MSCI, Morgan Stanley Research, December 2024. Note: Average relative valuations use 12M forward data where available (forward P/E data starts in 2003) and trailing data where forward P/E not available. 

What excites us about the current environment is that in a new regime, driven by different factors, different stocks are potentially going to perform well in the future. We don’t believe that growth and value are fixed categories – they are fluid and as regimes change stocks can transfer from one to the other. 

Favourable environment for value

Encouragingly for value investors, we think that many of the companies and areas that are likely to do well in an environment of increased investment and improving economic activity can be found in the value space.

Defence stocks are the most prominent example. Having been out of favour for years, they have rallied as investors expect them to benefit from Europe’s rearmament.

Banks are another area that could benefit. If the proposed stimulus measures boost growth and inflation in Europe, interest rates could stay higher for longer, which would be favourable for banks. A broad economic recovery and uptick in lending would also potentially be positive for the sector.

We are already starting to see banking systems in certain countries exhibit positive loan momentum, which is a major structural change from the post-financial crisis era. In future, we anticipate that European banks could become high return on capital, stable businesses, returning significant amounts of capital to shareholders.

“Many of the companies that are likely to do well in an environment of increased investment and improving economic activity can be found in the value space.”
 

Towards the end of last year, worries about the economic outlook began to weigh heavily on some of Europe’s more economically sensitive stocks. We observed cement, building, chemicals and materials companies trading on exceptional valuations and although we didn’t know when Europe’s fortunes might improve we thought that on a three-to-five-year view they were very good value.

We were just responding to the bottom-up valuation signals, but these are exactly the sort of companies that could participate in the reindustrialisation of the European economy.

Another potentially exciting factor is that the stimulus could create a positive flywheel effect that kick starts the European consumer. Any recovery here might support domestically-focused retailers, which have struggled lately as investors have tended to favour luxury consumer goods firms that are exposed to wealthy international consumers.

Positive outlook

European markets have made a strong start to the year but given the wide valuation discount to the US and the potential for fundamental drivers, we think the outlook remains positive. There is still a lot of uncertainty at the moment around issues such as tariffs and the Ukraine war. However, notwithstanding the potential risks, we believe it’s possible to construct a positive story on Europe today – and we’re particularly optimistic that the next chapter for Europe could offer plenty of opportunities for value investors.

Find out more about the M&G (Lux) European Strategic Value Fund

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast, nor a recommendation to purchase or sell any particular security.