Several key factors have fuelled the remarkable rise in European equities, from the beginnings of economic stabilisation to geopolitical developments...

US administration distances itself from universal tariffs

The absence of immediate tariffs when Donald Trump took office was a major catalyst for the rebound, with Canada, Mexico and China the first countries to be targeted. When it later transpired that Europe would not escape, markets nonetheless took comfort from the White House's preference for a targeted approach based on ‘reciprocity’ rather than blanket universal tariffs.

Given that the EU’s tariff differential with the US is just 1.2%, this proposal seems manageable. It should be noted, however, that the Department of Commerce reserves the right to include non-tariff barriers such as VAT in its calculations. If this is the case, Europe could face more severe trade restrictions.

For the time being, however, the markets remain on tenterhooks, trying as best they can to distinguish between political posturing and real change.

Economic optimism on the rise

The growing sense that economic indicators have bottomed out is also contributing to the current momentum. Key measures such as the ZEW survey, the IFO index in Germany and the European Commission’s economic sentiment indicator are all showing the first signs of a recovery. What's more, the start of a rebound in manufacturing PMIs (purchasing managers’ indices) suggests that the economic cycle may have finally bottomed out.

While these subjective data (surveys) are encouraging, the real test lies in the real data. Industrial production, business investment and consumer spending need to follow this upturn in sentiment if a sustainable recovery is to be confirmed.

Germany, once the economic powerhouse of the eurozone, is also showing tentative signs of improvement. Its Composite PMI index has moved back into expansionary territory after spending most of 2024 in the red zone. The results of the recent elections have boosted optimism about fiscal stimulus; the new coalition has no time to lose in revitalising growth.

Geopolitical developments

The war in Ukraine has been a major threat to European equities over the last three years, causing many investors to underweight the region. The prospect of a potential ceasefire initially brought the most reactive investors back into the market, in the hope of lower risk premiums on European equities, renewed confidence and, ultimately, faster economic growth. Larger institutional players are only just beginning to reconsider their exposures. If the world’s major asset managers gradually adopt a more neutral stance on Europe, this could be enough to flood the markets with liquidity and fuel the rebound even further.

One sector in particular has recovered strongly in Europe: defence. In the face of the US refusal to provide security guarantees for Ukraine, the radical change in European budgetary policy could well be a game-changer for the bloc.

Risks that could derail Europe’s recovery

Despite renewed optimism, a number of major risks could yet derail the recovery and shake investor confidence.

First, the future of trade remains unpredictable. Donald Trump has mentioned a 25% tax on “cars and other things,” rekindling fears of a new transatlantic trade conflict. If such a scenario were to materialise, it could disrupt supply chains, undermine the fragile recovery of the European manufacturing sector and weigh on corporate profits.

As for geopolitical developments, a peace agreement in Ukraine is far from certain, and even if it does materialise, its economic impact remains uncertain. While some European companies stand to benefit from the reconstruction of Ukraine, the accompanying financial burden could weigh on the public finances of EU states and absorb funds earmarked for investment in infrastructure, digitisation and other value-creating projects.

And although the war in Ukraine has been the catalyst for Europe’s energy crisis, it will not disappear overnight as a result of a peace agreement. At this stage, a full resumption of Russian energy flows seems unlikely. European companies could therefore continue to face higher energy costs than their American counterparts, putting a strain on their competitiveness.

Finally, let’s not forget that the European Central Bank is also still engaged in a delicate balancing act. With the markets anticipating two more rate cuts this year, the Frankfurt-based institution’s easing campaign is still under threat. While the Fed is obliged to keep rates higher in the longer term, the ECB has no such room for manoeuvre, at the risk of weakening the single currency (with a possible spike in inflation as a result).

Europe, the right balance?

Although risks remain, the change in sentiment is undeniable, and if fundamentals continue to improve, European equities could indeed make further progress.

Many investors are only just beginning to reconsider their exposure, which, combined with the fact that valuations remain cheap in relative terms, suggests that there is still plenty of upside potential.

However, three ingredients need to be in place to ensure that the momentum does not subside:

—real economic data should confirm the optimism seen in sentiment surveys;

—the ECB should continue to lower interest rates;

 —earnings momentum must continue.

None of these factors is guaranteed, even though share prices already reflect much of the upside potential.

When we eat cake, we are sometimes warned “a moment on the lips, an eternity on the hips.” Investors looking for a bigger slice of the European cake in their portfolios will therefore also be thinking about the long term, rather than hoping for quick and easy gains. Everyone knows how difficult it is to predict the ideal entry point, and the markets’ margin for fluctuation remains relatively wide, even if the European economy really has bottomed out.

Lionel De Broux is chief investment officer and Jade Marie Bajai is investment strategist at the Banque Internationale à Luxembourg.

This article was originally published in .