European stocks' 2025 outperformance is over, but don't forget the euro

European equities' early 2025 outperformance against the S&P 500 has largely faded, with the STOXX 600 now trailing year-to-date following a robust rebound in US tech stocks. Despite this, some investors highlight more reasonable European valuations and nascent EPS growth, though European stock gains are concentrated in defense and banking. Critically, the euro has appreciated 14% against the dollar year-to-date, nearing a four-year high, which significantly impacts cross-currency returns, making US assets less attractive for euro-based investors and enhancing European assets for dollar-based investors, with expectations for continued euro strength.

Analysis

The early 2025 outperformance of European equities over Wall Street has fully reversed, with the STOXX 600's year-to-date gain of 6.6% now slightly trailing the S&P 500's 6.8%. This shift is largely attributed to a powerful rebound in U.S. technology stocks, which constitute roughly one-third of the S&P 500 and have surged 24% since April, a dynamic unmatched in European markets. The European rally itself appears narrowly focused, with the defense and banking sectors accounting for over 50% of the STOXX 600's return from just 16% of its market weight. Valuations in these leading European sectors, such as Rheinmetall's forward P/E ratio exceeding 50, suggest they may be overextended. In contrast, the most significant and persistent trend is the euro's 14% appreciation against the dollar, which fundamentally alters cross-border investment returns. This currency movement has eroded gains on U.S. assets for euro-based investors—the S&P 500 is 9% below its peak when priced in euros—while simultaneously boosting European returns for dollar-based investors, pushing the STOXX 600 to a new all-time high in dollar terms.

Key Decisions for Investors

• Investors must critically assess their currency exposure, as the euro's 14% appreciation against the dollar is the primary driver of differential returns, benefiting dollar-based investors in Europe while penalizing euro-based investors in the U.S.
• Exercise caution with the concentrated European rally, as sectors like defense are trading at stretched valuations with forward P/E ratios above 50, suggesting a need to evaluate the sustainability of these specific gains.
• For U.S.-based investors, the strong euro acts as a significant tailwind, making European equities more attractive than their local currency performance indicates and warranting a review of geographic allocation.
• While U.S. valuations appear stretched, particularly in tech, recognize that the nascent recovery in European corporate earnings per share, if sustained, could lead to a narrowing of the transatlantic valuation gap.