The New Magnificent Seven?

European stocks are leading the global markets this year, with double-digit gains of over 11% as measured by the MSCI EMU (European Economic and Monetary Union) Index in U.S. dollars (USD). This more than doubles the total return of the S&P 500 Index at 4.6% year to date, adding to the outperformance by the MSCI EMU Index since the current bull market began in October 2022.

Let's explore five drivers helping Europe's markets outperform this year:

A new Magnificent Seven? – Europe's seven defense stocks are leading the way.
Easing off the debt brake – Germany's election may lead to more stimulus.
Lower energy prices – U.S. natural gas exports may lower prices in Europe.
Beating expectations – Economic data and earnings are better than expected.
Attractive valuations – Europe's stock market is still fairly valued.

A new Magnificent Seven?

The rise in European defense spending has lifted Europe's Defense and Aerospace industry. So far in 2025, the seven stocks that make up the MSCI EMU Aerospace and Defense Index have gained over 20%, leaving the U.S.'s Magnificent Seven stocks at a stall. Those gains add to the nearly 150% total return measured in U.S. dollars since the current bull market began on October 14, 2022, doubling the return of the S&P 500 Index over that period.

Since the 2014 Defence Investment Pledge, the North Atlantic Treaty Organization (NATO) members have promised to spend at least 2% of their gross domestic product (GDP) on defense, but actual expenditures only realized that target in 2024. Now, the prospect of U.S. President Donald Trump working on a ceasefire agreement with Russian President Vladimir Putin, without the participation of Europe or Ukraine, concurrent with considering a reduction in U.S. military presence in Europe has further raised expectations for more European defense spending.

The 2% target may become a floor for European Union (EU) defense spending going forward, with a higher percentage increasingly likely in the years ahead. If the percentage climbs to 3%, it may translate to 800 billion euros by 2029, almost four times the level of the mid-2010s. Increasing defense spending seems to be one issue that seems to unify Europeans, with the potential for financing being proposed from either joint European Union debt financing or the exclusion of defense expenditures from EU deficit rules for member countries.

Easing off the debt brake

There is a widening rift between growing public demand for more government spending and the self-imposed austerity mechanism known as the debt brake, which limits Germany's structural deficit to just -0.35% of GDP. As Germany is the largest economy in the EU, this fiscal austerity has kept a lid on overall debt growth in Europe—especially relative to the U.S. It also seems to have acted as a drag on growth in the region.

Following Germany's February 23 election, the Christian Democrats (CDU/CSU) and Social Democrats (SPD) will most likely join forces in a "grand coalition" government, with the CDU's leader, Friedrich Merz, as chancellor. These parties are in general agreement on boosting government spending via reform of the constitutional debt brake and having a more aggressive industrial and defense policy. This may be achieved through various methods: broadening the provision to allow deficits to fund specific investments such as infrastructure; letting the government carry forward unused spending capacity from previous years; or incorporating an emergency fund for periods such as the pandemic or war in Ukraine. If carried out, this added stimulus could mean faster economic growth which may support higher stock prices.

Lower energy prices

In January, Trump threatened the European Union with tariffs unless it stepped up its purchases of U.S. liquified natural gas (LNG). On February 7, when Japan's Prime Minister Ishiba met U.S. President Trump at the White House, he too offered to buy more U.S. LNG to help reduce the size of the trade gap. And, at his February 13 meeting with President Trump, Indian Prime Minister Modi also promised to buy more U.S. LNG. China may also favor buying more U.S. LNG as part of a deal on trade, although Asian buyers may likely resell that gas to Europe rather than transport it all the way to Asia and purchase supplies more locally (from Australia, for example) for domestic use.

The U.S. is rapidly ramping up LNG export capacity. The U.S. Energy Information Administration projects that North American LNG export capacity will nearly double from 12.7 billion cubic feet per day (Bcf/d) in 2024 to 24.4 Bcf/d in 2028. The Kansas City Federal Reserve survey of natural gas exploration and production companies, published January 10, 2025, revealed that producers would require $4.66 per MMBtu (million British thermal units), about 25% above the current price, to support a substantial increase in natural gas production. What does this mean for European energy prices? Natural gas units are different in Europe than the United States but converting both units to barrel of oil equivalents (bbl), natural gas prices in Europe are more than 300% higher than in the United States, as we can see in the chart below. Increasing exports, especially to Europe, should help to narrow the gap in European and U.S. gas prices, potentially bringing U.S. prices higher but bringing European prices down.

High energy prices have plagued Europe's economy in recent years, as you can see in the chart below. Lower prices stemming from more U.S. imports and a potential ceasefire deal in Ukraine could also return some continental flows of gas to Europe, likely alleviating price pressures.

Beating expectations

Europe's economic data has been exceeding expectations thus far in 2025, evidenced by the Eurozone Economic Surprise Index rising to 30 in recent weeks in contrast to U.S. data, as seen in the chart below. This index rises over zero when data is coming in better than the consensus economist forecasts tracked by Bloomberg. Germany and France are expected by those economists to deliver consistent quarterly growth in 2025, in contrast to the one-step-forward, one-step-back of quarters over the past two years. Formerly troubled southern European countries are booming, with Spain posting 3.5% GDP growth in 2024.

While the economic improvement could be put at risk by new U.S. tariffs, European markets have welcomed the idea that maybe the bark is worse than the bite on new tariffs from President Trump this year. Most announcements have remained merely threats. The latest from President Trump included a "reciprocal" tariff policy on imports that includes value added taxes (VAT) of trading partners and, more specially, tariffs of 25% on pharmaceuticals, semiconductors and cars that could go into effect on April 2. It remains unclear which categories of medicines, chips, and autos may be subject to this tariff.

Nevertheless, the impact on the eurozone economy would likely be relatively small, since exports to the U.S. of products across these three areas amount to just 5% of overall eurozone exports. Furthermore, we note that demand for pharmaceuticals and semiconductor equipment tends to be relatively insensitive to price changes, meaning additional tariff costs may be more easily passed on to U.S. consumers. Many large European producers of drugs and cars already have significant production facilities in the U.S., which also reduces exposure to potential new tariffs.

Attractive valuations

Despite the outperformance of European stocks, they are not historically expensive. The 12-month forward price-to-earnings (P/E) ratio for Europe's stock market is close to its 20-year average at 13.7 as you can see in the chart below. This seems particularly attractive when compared to U.S. valuations for the S&P 500 at 22.3, much higher than its 20-year average of 15.9.

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With the European Central Bank (ECB) widely expected to cut rates steadily through the middle of 2025, easier monetary policy could lift the stock market's price-to-earnings ratio, as took place during prior rate-cutting cycles (2009, late 2011 to early 2016, 2020, and 2024).

Chasing performance

These five reasons European stocks are outperforming may continue to reward investors this year, sustaining the bull market in Europe's stocks that began nearly two-and-a-half years ago. While Europe's markets have been outperforming, it appears that the average investor has yet to catch on. Historically, investors tend to chase performance and shift their money based on the past three-year returns, as you can see in the chart below of weekly money flows and the trailing three-year S&P 500 and MSCI EMU total returns. Investors have been heavily favoring U.S. markets over international (where European markets make up the biggest share).

We expect European stocks have a good chance of continuing their outperformance this year. But even if we assume no difference in relative performance between Europe and U.S. stock markets from now until October, the MSCI EMU Index would likely outperform the S&P 500 Index on a three-year trailing basis by October of this year. History suggests this shift in relative performance could be a catalyst for a reversal of investor money flows as they shift in favor of international stocks.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.

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The MSCI EMU Aerospace and Defense Index is composed of large and mid-cap stocks across 10 Developed Market countries in the European Economic and Monetary Union (EMU) classified in the Aerospace and Defense industry group (within the Industrials sector) according to the Global Industry Classification Standard (GICS^®).

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Citi Eurozone Economic Surprise Index is an indicator used to measure data surprises relative to market expectations for the Eurozone. A positive reading means data surprises have been stronger than expected, and a negative reading means that data releases have been worse than expected.

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