It would take a brave analyst to say that 2025 is the year that European stocks finally outperform their US counterparts, but the conditions could be right for this to happen.
Over the last five years, US indexes have comfortably beaten their European peers, a period that included close to double-digit inflation at one point, meaning investors barely broke even in real terms.
European Market Valuation is Key
Why do I think Europe can finally turn things around? Firstly, valuation. Up to very recently we’ve been saying that value exists in the North American market. Especially when you dig deep into areas like small-cap and value stocks. But what we’ve seen over the last quarter is a catch-up effect in the US, with even these lesser-loved areas seeing gains, bringing their valuations much closer to our fair value estimates. The broader US market now trades at around a 6% premium to our fair value estimate. Europe, by contrast is roughly 5% undervalued, making it an appealing proposition as we move into 2025.
What could close the valuation gulf between the US and Europe? Firstly, the relative economic gap between Europe and the US is closing. The International Monetary Fund expects economic growth of 2.2% in the US and 1.6% in Europe this year. So while the US is unquestionably growing more quickly, the US is no longer expanding at more than twice the rate of Europe. Then interest rate expectations come into play. Economists are expecting 100 basis points of cuts in Europe, against just 25 basis points in the US. This means businesses in Europe will benefit to a much larger degree from lower debt service payments, conditions which should be much more supportive for European stocks.
Could Consumer Stocks Bounce Back?
For much of 2024 we highlighted the relative value in European consumer sectors, with both consumer discretionary and staples trading at attractive discounts to our fair value estimates. But once again there is a difference between something being cheap and something being ready to turn around, and these consumer sectors massively underperformed the general European market in 2024, generating just low single-digit returns.
Why should 2025 be any different? Consumer firms have struggled in the wake of the pandemic with high inflation and the unpopular task of passing through price increases to end consumers, or alternatively letting margins suffer. With inflation now close to central banks’ 2% target, many consumer firms are now seeing volumes improve, as consumers can finally afford to buy more. Interest rates are also a swing factor, which will ease the burden on indebted households, freeing up more disposable income for consumer-related products.
Value and Small-Cap Stocks: Time to Shine?
Given the relatively weak state of the European economy, it makes sense that small-cap and value stocks have been trading at a material discount to the general market. Investors have preferred to stay invested in large-cap stocks, which are perceived as the safer option. And they have also shied away from traditional value stocks, with the perception that many of these names represent the old economy. Currently small-cap stocks trade at a near 30% discount to our fair value estimate and value close to a 20% discount.
One big change we’ve observed in US markets over the last quarter or so is the closing of the valuation gap between these categories and the general market. Market conditions are improving in Europe, with the big differential being rate cuts. As interest rates fall even further, investors could be persuaded to allocate more capital to small-cap and value stocks, bringing the valuation gap closer to what we are seeing in the US currently, where small cap trades at just a 7% discount, and value now trades at a 1% premium.
Oil Prices and Stocks in Focus
With Trump now back in power and OPEC cuts about to end, everyone expects oil supply to outweigh demand in 2025. Meanwhile the World Bank is warning that the risk is to the downside for global growth, which would subdue demand. This imbalance, if it materializes, could lead to subdued or even depressed oil prices this year.
Total Energies Stock Is Undervalued
Source: Morningstar Direct.
For the oil and gas industry this has triggered recent weak bouts in share prices. We see significant upside to the share prices of European oil majors like TotalEnergies TTE and BP BP. and we see even higher upside potential to oil services stocks.
For the rest of the European market, lower energy prices might be a welcome boost, particularly to German industrial firms, many of which have been struggling to remain competitive since the cheap Russian gas supplies were cut off.
Michael Field, CFA, is European Market Strategist for Morningstar. Read more of his columns here.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
