What’s next for Europe?

Key points

• European equities have become increasingly popular, after significantly outperforming in 2025.
• February’s German election result was largely as expected, and had little effect on markets. But a much-anticipated removal of the country’s debt brake isn’t guaranteed.
• Meanwhile, the US government’s strategy over negotiating a Ukrainian peace deal, is a potential “game changer” for Europe. 
• But, it could spark a long-term period of outperformance for the region’s assets, if managed well. That said, it’s unclear if the continent can rise to the challenge.

European assets have outperformed in 2025, despite several geopolitical flashpoints, not least the actions of the US administration over Ukraine. With February’s German election now out of the way, are prospects for the region as bright as many think?

All the concerns that were cited in 2024 as reasons to avoid investing in Europe, have become reasons that seemingly favour boosting investment in the region. Indeed, the uncertainty linked to the German vote, the risk of US tariffs and the (possible end of the) Ukraine war, are now being spun as potential positive catalysts for the bloc.

What next?

The German election result was, by and large, as expected. The conservative Christian Democratic Union of Germany (CDU)/Christian Social Union (CSU) took the largest share of the votes. Meanwhile, the far-right Alternative for Germany (AfD) performed well, but not by enough to scare markets. That said, the enthusiasm around removing the so-called debt break, which would allow the government to boost public spending, might be premature.  

Indeed, a coalition needs to be formed, and this process will likely take weeks, if not months. Beyond that, when combined, populist parties (the AfD and Linke) have secured enough seats in the Bundestag to potentially block fiscal reforms. 

On the other hand, the decision by the US administration to deal with Moscow directly, to initiate Ukrainian peace talks, is somewhat of a “game changer” for Europe. First, it means that the continent may need to reconsider guaranteed American support, when it comes to security and defence. Second, any negotiated peace could involve significant concessions for Russia, with all the geopolitical ramifications, and potential spike in market volatility, that might entail.

Beyond defence

For now, investors seem to believe that the defence sector will be a key winner of a change to a ‘new world order’, and any subsequent European rearmament initiative. This is obvious. But such a geopolitical shift would not just affect one sector. The consequences should be far broader. To some degree, this could be a catalyst for the region, an opportunity to rethink its alliances and dependencies, from energy access to end-demand exposure and its overall place in the global economy.  

Unfortunately, turning around the bloc won’t happen overnight. It would need strong political will. In the meantime, it is likely that Europe will spend more on tanks, missiles and other defence equipment. However, such expenditure usually does little to boost productivity and long-term economic growth potential.

Optimism could fade 

In this regard, investors’ newfound love for European assets might seem misplaced. Indeed, the outlook isn’t much better economically speaking, it just isn’t as bad as was feared. Similarly, the geopolitical landscape is even more challenging than it was last summer. 

But, of course, everything has a price. European stocks had been trading at a historical discount to their US counterparts. Unfortunately, following a three-month rally, this has shrunk. The Euro Stoxx 50 of the bloc’s 50 highest-capitalised companies now trades at a much more reasonable 30% discount to the S&P 500 (versus 40% in November). The same is true on an absolute basis, with the index’s earnings multiple close to its 10-year average. Similarly, the euro, which was on course to fall through the parity line with the US dollar, is hovering at around $1.05. 

Somewhat surprisingly, the market barely reacted to the German election. This suggests that much had already been priced in, and that despite the potentially increased risk that the debt brake will stay, markets remain hopeful.

Back to basics

Momentum is a powerful thing in financial markets. Despite strong inflows into European assets this year, investors are unlikely to be significantly overweight the region. As such, some latecomers could still join the party and drive more inflows, allowing for further outperformance. 

That said, the rush to European assets appears to be on its last legs. A period of consolidation now seems inevitable in the coming months. Longer term, the continent has a generational opportunity to reinvent itself. If negotiated correctly, this could lead to a period of much more sustainable outperformance for the continent’s assets. Until then, though, investors should focus on what the region is good at: producing companies that are global leaders in their respective fields.