Investment landscape amid policy tailwinds and trade risks. Despite persistent global uncertainty, Europe equities have staged a strong performance in 2025. The STOXX 600 is up 7% YTD, recovering 14% from recent lows. Earnings downgrades for the region have been limited as trade-related concerns have been offset by a stronger-than-expected Q1 earnings season. However, risks remain concentrated in key export-facing sectors – including autos, steel, pharmaceuticals, industrials, and luxury goods – which are vulnerable to tariffs ranging from 10% to 50%. The euro’s appreciation poses an additional challenge for exports.

Balancing these pressures, the region benefits from several tailwinds: lower interest rates, a substantial fiscal expansion from Germany, and an emerging uplift from AI-linked industrial investment. While the OECD has revised its global growth forecast down by 20 bps since Mar 2025, euro area projections remain stable at 1.0% for 2025 and 1.2% for 2026. These forecasts are supported by robust labour markets, policy easing, and fiscal measures that are likely to extend their impact well into 2026.

Europe as a safe haven. Despite macro headwinds, we remain overweight on Europe given its defensive sector tilt, relative valuation appeal, and Germany’s proactive fiscal stance. Together, these factors help cushion against global volatility and make Europe an increasingly attractive allocation for global investors seeking resilience and value.

Policy flexibility and monetary support. The ECB’s shift toward an accommodative stance has provided a key policy cushion. Through 1H25, it cut interest rates by 100 bps, bringing the deposit facility rate to 2.0%. With the euro’s appreciation tightening financial conditions, there is scope for additional easing – particularly if disinflation continues and tariff threats remain unresolved. We expect further rate cuts toward the lower bound of the ECB’s estimated neutral range (1.75–2.25%).

EUR resilience and shifting capital dynamics. The euro has defied expectations, appreciating by 10% YTD against the US dollar despite a widening rate differential that typically favours US assets. This strength reflects shifting capital flows and renewed optimism toward the European outlook, underpinned by two key drivers:

1. Expectations for Europe’s “Readiness 2030” initiative to address structural stagnation.
2. Diminishing appeal of US assets amid fiscal concerns, tariff risk, and geopolitical tensions.

ECB President Lagarde’s call for a more internationalised euro also signals a broader ambition to attract global capital. In tandem with regulatory risks in the US, such as potential withholding tax changes under Section 899, this backdrop is encouraging a rotation towards euro-denominated assets.

Combined with Europe’s underweight positioning in global portfolios, a stronger euro and easing monetary stance create favourable conditions for inflows into both bonds and equities.

Germany: Fiscal Expansion Amid Tariff Risks

As the EU’s top exporter to the US, Germany is especially exposed to any escalation in transatlantic trade frictions. The US accounts for c.10% of German exports, with key sectors at risk including:

• Autos: 23% of German car exports head to the US
• Pharmaceuticals and Medical Equipment
• Machinery and Electrical Equipment

Given its economic size and export dependency, Germany is the most critical European market to monitor for trade-related developments. To offset external risks, Berlin has unveiled an ambitious EUR1tn 12-year fiscal plan focusing on infrastructure and defence. This programme not only counters potential trade shocks but also highlights the strategic use of fiscal tools to preserve macroeconomic stability.

AI Infrastructure: Opportunities and Structural Pressures

The accelerated adoption of AI is transforming Europe’s industrial landscape, especially through a boom in demand for data centre infrastructure. This is driving robust growth in areas such as semiconductor manufacturing, automation, and high-performance computing.

However, the rise of AI also presents cross-sector challenges:

• Energy and Grid Stress: AI-optimised data centres consume vastly more power than conventional infrastructure, requiring urgent investment in grid modernisation, renewable integration, and storage capacity.
• Sustainability: Environmental issues – including emissions, water usage for cooling, and waste heat – are becoming more prominent, elevating the role of advanced cooling and efficiency technologies.
• Labour and Skills: Scaling and maintaining next-gen infrastructure requires highly specialised skills across engineering, HVAC (heating, ventilation, and air conditioning), and digital operations, creating a parallel need for workforce reskilling and training programs.

AI remains both a driver of capital investment and a stress test for energy, environmental, and labour systems.

Structural Advantages of the European Equity

i. Defensive sector composition

One of the key structural strengths of the Europe equity market lies in its sectoral makeup, which is relatively defensive in nature. A significant proportion of market capitalisation is concentrated in sectors such as consumer staples, healthcare, and utilities – industries that tend to exhibit more stable earnings and resilient cash flows regardless of the economic cycle. This defensive tilt provides a natural hedge against macroeconomic volatility, making European equities comparatively more stable during periods of global uncertainty, slowing growth, or geopolitical tension. Moreover, the healthcare and consumer staples sectors are supported by long-term structural drivers such as aging demographics, demand for essential goods, and public health expenditure, further enhancing their appeal.

ii. Attractive dividend yields

European equities continue to offer comparatively higher dividend yields than their US counterparts, reflecting a market culture that prioritises shareholder returns through regular cash distributions. This dividend premium is particularly appealing in the context of declining or low interest rates, as investors increasingly seek stable sources of income outside of traditional fixed-income instruments. In addition, many European companies maintain strong balance sheets and conservative payout policies, providing a degree of reliability in dividend payments. For income-oriented investors, this yield advantage – combined with the market’s defensive profile – positions Europe as a compelling allocation within a diversified global equity portfolio.

iii. Valuation appeal and capital discipline

In addition to its sectoral and yield advantages, the European equity market also trades at more attractive valuation multiples compared to the US, particularly on a P/E and P/B basis. This valuation discount offers potential for upside re-rating, especially if earnings expectations improve or macro headwinds abate.

Sector Strategy: Navigating Key Macro Drivers

European sector earnings will be shaped by a blend of cyclical and structural forces. Five major themes will influence relative performance:

1. Euro appreciation pressuring export-heavy sectors.
2. Tariff escalation/de-escalation, particularly affecting autos, luxury, industrials, and materials.
3. Lower interest rates supporting rate-sensitive sectors such as utilities and real estate.
4. German fiscal spending boosting domestic demand and infrastructure activity.
5. AI-led demand shifts reshaping tech, industrial, and utility sectors.

We outline sector-specific implications below:

Industrials

Europe’s industrial firms excel in automation, electrical systems, and precision manufacturing – often underpinned by high-margin and recurring-revenue models. These businesses are well-positioned to withstand cyclical pressures thanks to strong IP, software support, and licensing streams.

Defence-related names are gaining traction as European nations increase defence budgets, particularly in aerospace and cybersecurity. This theme aligns with geopolitical shifts and long-term modernisation goals.

Utilities

As a core defensive sector, European utilities offer regulated cash flows, stable dividends, as well as increasing alignment with decarbonisation and energy transition agendas. Rising demand for electrification and clean energy investment, combined with policy support, makes this sector structurally attractive, particularly amid falling rates.

Consumer Staples

A core pillar of defensive strategies, European consumer staples are backed by globally recognised brands and inelastic demand. Firms in this sector typically deliver strong cash flow, attractive dividends, and pricing power.

Current macro tailwinds, such as positive real income growth, solid household balance sheets, and accelerated credit expansion, support consumer spending. As ECB rate cuts progress, falling savings rates could further unlock consumption. A stronger euro and pound are also curbing imported inflation, strengthening discretionary purchasing power.

Meanwhile, trade diversion from Asia is improving cost structures for retailers, boosting margins and earnings potential.

Consumer Discretionary

The luxury segment is vulnerable to trade disruptions. US–EU tariff negotiations pose meaningful risks, with little likelihood of sector-specific exemptions due to limited US manufacturing capacity. Brands may raise US prices, encourage tourism to Europe, or shift limited production abroad, but passing costs fully to US consumers is unlikely given the weak sentiment.

We prefer luxury firms with lower US exposure, strong pricing power, and robust fundamentals, as they are better equipped to weather near-term pressures.