European economies and markets have trailed the United States for more than a decade. The conventional wisdom has considered Europe to be in a permanent state of malaise.
And now, suddenly, Europe is drawing attention. Its markets outperformed the United States and global peers at the start of 2025. Might this be the start of something big? Could Europe prevail for longer? And should investors take another look at Europe?
We think so. But that comes with caveats, of which the most significant would be an escalation of global trade wars culminating in significant economic weakness, perhaps even recession.
Germany changes course
We begin by asking, why is Europe now garnering investor attention?
The primary reason is the hope for significant fiscal stimulus—primarily for national defense and infrastructure—and the expectation that it will lift Europe’s cyclical growth and earnings prospects.
Indeed, the outlook for European growth has brightened. And that is because both monetary and fiscal policy stimulus are acting as dual catalysts.
Falling inflation over the past two years has enabled the European Central Bank to cut interest rates six times (by a quarter point each instance) since 2024. And soon, the big bazooka will likely arrive in the form of fiscal easing, both from Germany and from the European Union (EU) more broadly.
In response to both domestic and external pressures, the incoming German coalition government [the Christian Democratic Union of Germany (CDU)/Christian Social Union in Bavaria (CSU) and the Social Democratic Party of Germany (SPD)], together with the Green Party, have passed legislation through the lower house (Bundestag) and the upper house (Bundesrat) that amends Germany’s constitutional “debt brake” (Schuldenbremse). All that is now required is the German President’s signature, which we believe is a formality.
By amending the rules governing government indebtedness, the new coalition government aims to create considerable latitude to boost spending on national defense and security, as well as for public infrastructure.
Specifically, the incoming German government has pledged to spend €500 billion [equivalent to a whopping 11.6% of gross domestic product (GDP)] over the coming years on national defense, security and infrastructure, of which €50 billion is earmarked for Germany’s energy transition. Moreover, investment spending for defense above 1% of GDP is permanently excluded from the “debt brake.”
In total, estimates suggest that some €400 billion (9.3% GDP) are slated for national and European defense.1 That already staggeringly large source of fiscal expenditure will roughly double at the European level, insofar as the EU has pledged a similar amount of new expenditure for military, defense and national security purposes.
To put this in perspective, the planned new spending should dwarf any fiscal stimulus seen in the post-war era on either side of the Atlantic, excepting what took place during the COVID-19 pandemic.
In our opinion, it is difficult to overstate the historic and economic impact of what potentially lies ahead for Europe.
This groundbreaking move by Germany lends support to the European Commission, which is pushing EU member countries to relax their spending rules to enable the rest of the continent to scale up its investments in defense and infrastructure.
Moreover, the EU’s fiscal support incentivizes investment in European firms, which reflects the growing realization that the United States (and the Trump Administration in particular) has become a less reliable military ally. The result will be a re-energized European industrial base, which has recently been bolstered by a competitive advantage via lower electricity prices.2
The European Commission has also announced the ReArm Europe Plan, which provides fiscal space for EU members to raise their national defense spending by 1.5% per annum, equivalent to €650 billion over four years. It also provides a new borrowing facility of a further €150 billion for EU-sourced defense investment.
These initiatives, if realized, will promote considerable public and private sector activity. Accordingly, various public and private sector entities have sharply revised higher their real GDP forecasts for Germany and Europe, particularly for 2026.
For instance, the Kiel Institute expects a German fiscal impulse of more than 1% of GDP to lift Germany’s GDP growth from near 0% this year to 1.5% next year—its most marked acceleration since the pandemic.3 The spillovers to the rest of the euro area should add nearly a half percentage point to overall European growth by 2026.
In contrast, estimates for US GDP growth have recently been revised lower because of the sharp increase in US economic policy uncertainty (e.g., volatile tariff announcements and federal government layoffs).
European earnings and valuations
For investors, the upgrades to European real GDP growth are significant. Profitability is highly cyclical, improving as real activity accelerates. Notably, European earnings estimates are climbing in absolute terms and relative to the United States. Over the past month, for example, European and German consensus earnings forecasts have been raised from 5%-12%. Meanwhile, according to FactSet, earnings revisions for US companies (based on the S&P 500 Index) have generally moved lower and at a faster pace of downward revisions than is typically observed in the first quarter of the year.4
Rising profits expectations are leading investors to reassess the value proposition of European equity markets. Long a laggard in global equity market performance, European stocks have generally traded on a 30%-40% discount to their US peers.5 Given the directional decoupling of profits estimates, however, we believe Europe’s lower valuations are beginning to attract bargain hunters.
European sectors
Unsurprisingly, European sectors most likely to benefit from increased government spending on defense, security and infrastructure have advanced sharply this year. That includes companies in aerospace, defense contracting and information technology. It also mirrors a shift in investor attitudes in the United States and elsewhere in favor of sectors, styles and companies that had underperformed in recent years during the narrow market leadership of the Magnificent Seven.6 Europe is benefiting not only from higher expected growth and earnings, but also from a greater willingness of investors to broaden their investment holdings.
Risks to the view
As noted at the outset, we believe a primary risk is that of escalating tariff wars, which could potentially erode economic and financial confidence, precipitating a significant economic slowdown or even recession.
Like other investors, we struggle to quantify the probability of trade war escalation. The concern is not that Europe is highly dependent on exports to the United States (which make up less than 10% of total exports for most European countries). Rather, the concern is the uncertainty a trade war could inflict on all economies.
A second risk resides in the willingness in Europe to take advantage of new-found fiscal headroom to boost spending. Politicians, after all, make promises they sometimes fail to keep.
Here, however, the risks appear smaller. European perceptions of Russia’s threat are undoubtedly grounded in the Russia-Ukraine war. And for Europe, the United States has become a less reliable defense partner. Hence, it seems probable to us that Europe is serious about implementing its commitment to common defense and security.
Investment conclusions
Finally, is it too late to take advantage of the positive turn in European markets? After all, Europe has already spurted ahead in early 2025. In the first three months of this year, the broad European equity index (Stoxx 600) is up 8.5%, while the S&P 500 has stumbled to a -3.5% return.7 That 12-percentage-point return differential is large and unusual.
In our view, that is not a sufficient reason to deter investors from shifting toward Europe.
The market’s performance this year reflects investors’ warranted appraisal of factors now working in Europe’s favor—including improving cyclical growth and earnings prospects, more favorable valuations, and greater investor certainty. These appear to us to be key 2025 European advantages relative to what is on offer in the United States.
In short, the old world is becoming a new destination for investor attention. In our analysis, that shift is justified and still in its early stages.
For investors, we believe it is time to consider Europe.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically.
Companies in the infrastructure industry may be subject to a variety of factors, including high interest costs, high degrees of leverage, effects of economic slowdowns, increased competition, and impact resulting from government and regulatory policies and practices.
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1. Source: Eurostat. Analysis by Franklin Templeton Institute. There is no assurance that any estimate, forecast or projection will be realized.
2. Source: Catechis, Kim, and Kosinska, Karolina. “Consider This: Could Europe build a structural advantage via cheap electricity?” February 2025.
3. Source: “Economic Outlook.” Kiel Institute of the World Economy.
4. Source: “Analysts Making Larger Cuts Than Average to EPS Estimates for S&P 500 Companies for Q1.” FactSet. February 28, 2025. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance. See www.franklintempletondatasources.com for additional data provider information. There is no assurance that any estimate, forecast or projection will be realized.
5. Source: Bloomberg.
6. The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
7. Source: Bloomberg, as of March 20, 2025. The Stoxx Europe 600 measures European stocks designed by STOXX Ltd. This index has a fixed number of 600 components representing large-, mid- and small-capitalization companies among 17 European countries, covering approximately 90% of the free-float market capitalization of the European stock market (not limited to the eurozone). Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance. See www.franklintempletondatasources.com for additional data provider information.
