European equity markets have rallied so far in 2025 and their relative performance was even better, with rival equity markets seeing declines over the same period. The big question now is where European stocks go from here.

There are two potential drivers of the next moves for equity markets: valuation and momentum.

In the fourth quarter of 2024, European equities were trading at a 5% discount to our fair value estimates. That didn’t leave a huge amount of upside. But relative to US markets, which were at the time trading at a premium of around the same magnitude, European markets were an attractive proposition.

The rally in European equities this year has had the effect of pushing up valuations, bringing them even closer to our fair value estimate than last quarter. As things stand, the European market is trading just 2% below our fair value estimate. So investors shouldn’t be expecting another big rally in the coming months.

The investor Howard Marks once described equity markets as a pendulum, swinging from being overvalued to undervalued, and spending little time in the center. So, while markets are now essentially fairly valued, that does not mean investors will suddenly stop pouring money into European equities.

Europe’s Economic Prospects Are Improving

If anything, macroeconomic conditions over the last quarter have improved, which makes the prospect of European equities even more appealing to investors:

• European inflation sits at just 2.2%, the lowest level in the western world, putting us within reach of the European Central Bank’s 2% target.
• Interest rates in Europe have been cut to 2.5% and forecasts are pointing to another 50 basis points of cuts by the end of the year. This compares favorably to the US, where rates are still at 4.5%.
• In 2024 Europe delivered GDP growth of just 0.9%, compared to 2.8% in the US. But 2025 forecasts are pointing to a much narrower gap. Asset manager Vanguard forecasts Europe growing at 1.6% in 2025, just 10 basis points shy of their US forecast.

Add to this the recently announced German infrastructure package and the news flow for Europe is looking pretty good at the moment. Germany’s plans would mean an extra EUR 500 billion in spending in the domestic economy, which could of course spread further across Europe.

To put this in context, the Inflation Reduction Act in the US was worth a total of $900 billion (EUR 741 billion), but spread out across a much larger economy and population.

European Stock Sectors to Watch in the Second Quarter

Defense sector: The most recent German defense and infrastructure package has only strengthened the tailwind behind the sector. The market is slowly waking up to the reality of higher defense spending by governments, but we still think this rally has room to go further.

Investors have also underestimated the longer-term impact of the Ukraine war. Even if the conflict ended tomorrow it would likely take Germany a decade to replenish the munitions they have supplied to Ukraine.

The proposed increase in defense spending is not a short, or even medium-term phenomenon; Morningstar analysts are forecasting spending of around 3% of GDP out past 2032.

Rheinmetall RHM shares having already risen by 120% in 2025, but we have just raised our fair value estimate to EUR 2,200, implying an upside of two-thirds from the current share price.

Automotive sector: This is another area that could see an uplift in the coming months. Stocks like Volkswagen VOW3 have been through the wringer over the last few weeks, most recently with the announced US tariffs. There is certainly plenty of bad news around the sector, but at this point any good news could move the needle back into positive territory. Specifically, we believe the German infrastructure package could be a catalyst. Auto makers have long complained that underfunded infrastructure has been holding them back, so changes here could be a simple first step to boost the sector.

Consumer sector: We would highlight a couple of sub-sectors: brewers and distillers. Trump’s tariffs have done distillers no good, with Diageo DGE down 20% year to date. Meanwhile, brewers are still struggling with the post-pandemic beer slump. The good news though is that valuations in both areas are now very attractive. Lower interest rates in Europe should boost consumer spending over the coming months, while lower inflation should further ease input cost pressure that had plagued many of these firms.

Utilities sector: This sector underperformed the market in the first quarter, but we see the regulatory environment in parts of Europe improving, particularly in Spain and Germany. On top of this, lower interest rates in the second quarter should benefit these stocks in two ways, first in terms of lower debt payments, but also in making their dividends more attractive relative to government bonds. We see opportunities in diversified utilities, power producers and of course renewables.

Expect More Stock Market Volatility in the Second Quarter

Some of the risks that investors faced in the first quarter, like the German election, have diminished- others have not. If anything, the risk of a US trade war has stepped up, with the two regions already exchanging blows. It’s not likely to end there, so we believe investors should brace for more volatility.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.