Why can't European stocks "outperform" anymore?

Despite the market remaining relatively optimistic about European stocks, the outperformance of European stocks relative to the MSCI Global Index has basically been reversed. Moreover, Bank of America believes that European stocks still have a downside potential of 10%.

On July 25, according to the Wind Trading Desk, Bank of America released a latest research report indicating that the current valuation of European stocks has already priced in too many positive factors, and the Stoxx 600 index has about a 10% downside potential in the future. Compared to defensive stocks, European cyclical stocks may still decline by about 15% from their current 30-year relative high.

Bank of America analyzes that there are three main reasons behind this. First, the market had overly optimistic expectations for the recovery of the European economy in March. Second, European companies are mainly export-oriented, and the strengthening euro has dragged down corporate profits, lowering the valuation of European stocks by 8-9%. Third, since the European market is dominated by value stocks, the recovery of growth stocks in the U.S. has also suppressed the attractiveness of European value stocks.

Market Optimism Towards Europe Has Been Overpriced

In the first half of 2025, there was a dramatic reversal in market style, with funds shifting from U.S. stocks to European stocks, mainly influenced by two factors: first, a wavering confidence in the "American exceptionalism" narrative, and second, optimistic expectations for large-scale fiscal stimulus in Germany.

These factors collectively drove significant capital inflows into the European stock market, resulting in nearly 15% excess returns for the European Stoxx 600 index relative to the MSCI Global Index (mainly composed of U.S. stocks) from December 2024 to March 2025.

Nevertheless, the market still generally bets that European stocks will continue to outperform. Bank of America's July "European Fund Manager Survey" shows that investors' overweight position in Eurozone stocks is close to the highest level in the past seven years, while the allocation to U.S. stocks is near the lowest level in the past 20 years.

From an economic perspective, the macro fundamentals in Europe have indeed improved relative to the U.S. Specifically, the gap between the Eurozone Composite PMI new orders and the U.S. Composite PMI new orders has significantly narrowed. Last November, the difference was 8 points, which shrank to 4 points in March this year, and further decreased to 3 points in July. Additionally, the macroeconomic surprise index for the Eurozone relative to the U.S. has rebounded from -60 points in December last year to +30 points currently.

However, from a price trend perspective, the relative strength of the European stock market has clearly weakened, and since mid-March this year, the outperformance of European stocks relative to the MSCI Global Index has basically been reversed.

Why has the European stock market stopped outperforming globally? Bank of America believes there are three main reasons.

1. The market had overly high expectations for Europe in March.

Although the relative growth momentum in Europe has improved, the extent of improvement is far below the level that the market "priced in" in March. At that time, the relative valuation level of the European stock market implied that the Eurozone PMI would further improve by more than 10 points relative to the U.S. PMI, but it only improved by 1 point in reality. Following the subsequent correction in the European stock market, its price trend has basically returned to the reasonable path derived by Bank of America based on the "relative PMI and actual interest rates" model.

2. The strengthening euro has dragged down corporate profits.

Since February, the nominal effective exchange rate of the euro has cumulatively risen by about 7.5%, reaching a 10-year high, which has put pressure on the profits of export-oriented European companies, thereby affecting stock price performance. According to Bank of America's analysis of the Stoxx 600 index, the appreciation of the euro has lowered the "macro reasonable valuation" of the European stock market by about 8-9% In contrast, the trade-weighted index of the US dollar has fallen by 8% since January, which has helped boost the performance of US and global stock markets.

3. The rebound of US growth stocks has also suppressed the performance of European value stocks.

In Europe, due to the strong rise in the financial sector, value stocks have continued to outperform growth stocks. In the US, however, the situation is quite the opposite, with the growth-stock-dominated Nasdaq outperforming the S&P 500 index by 6% since April. Given that the European market is dominated by value stocks, the relative weakness of US value stocks compared to growth stocks suggests that the attractiveness of European stocks in the global asset landscape has declined.

Global growth prospects under pressure, Europe particularly vulnerable

Bank of America has downgraded its rating on European stocks from overweight to neutral and continues to underweight cyclical stocks while overweighting defensive stocks in its sector allocation. The core of the bank's judgment is that, as of March this year, the relative prices of European stocks have already priced in too many positive news, leaving limited room for further increases, and the macro backdrop does not support a new round of European stock rebounds.

On one hand, although the US has recently reached several trade agreements that have alleviated uncertainty, it has also driven the continuous rise in the "effective tariff level" in the US. Bank of America’s global economists have recently indicated that the effective tariff rate in the US could rise to 16%, rather than the previously assumed 10% in the baseline scenario, which will increase the downside risks to global economic growth.

Additionally, Bank of America expects that the Eurozone will experience nearly "zero growth" in the second half of 2025. These combined factors create a systemic downside risk to global growth expectations, with Europe, as an export-oriented economy, being particularly affected.

Bank of America points out that the current absolute valuation of the European stock market already implies expectations for a significant economic improvement, which diverges from the macro fundamentals. Under Bank of America's current macro forecasts, the Stoxx 600 index has about 10% downside potential, and European cyclical stocks could fall by about 15% from their current 30-year relative highs compared to defensive stocks