A magnificent outlook for European equities?

Summary

• The correction in highly valued US technology stocks indicates a shift of capital into other sectors.
• European equities may benefit from supportive monetary policy, structural transformation and the prospect of increased investment.
• European small caps, in particular, are showing potential.

In the iconic 1960 Hollywood classic ‘The Magnificent Seven’, a group of gunslingers defend a small  Mexican village from ruthless bandits. Today, the term ‘Magnificent Seven’, has taken on a new meaning in the world of investing – referring to the seven dominant US tech giants: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. These technology stocks have delivered extraordinary returns to investors for years, commanding a level of influence rarely seen in any industry before.

But recently, the narrative of these heroes seems to have taken an unexpected turn. Soaring corporate valuations and growing concerns about the economic conditions in the US have led to significant price losses at the beginning of 2025. Meanwhile, the situation in Europe is quite different, with markets currently reaching new highs, particularly in Germany.

New highs in Germany and Europe

Germany is leading the way, while the US is falling behind – with notable market losses surprising many investors. After the changes in US government, many had anticipated a resurgence of “Trump euphoria,” assuming that sweeping tax cuts and deregulation would drive corporate profits and stock market gains. Meanwhile, Europe – often viewed as the eternal loser, held back by its notoriously weak growth, excessive bureaucracy and political paralysis – seemed unlikely to catch up.

Political reforms could unlock new momentum

Few people had foreseen that Europe, of all places, could find its way back to new strength. However, the Europeans seem to be ironically drawing strength from the geopolitical tensions in the U.S.

Germany, in particular, is preparing to make substantial investments in defence and infrastructure renewal – both seen as critical to reviving its faltering economy. Vincenzo Vedda, Chief Investment Officer at DWS, has already raised his estimate. At the start of the year, he projected that German GDP growth of just 0.9 per cent for 2026. Now, he expects growth to reach 1.6 per cent.^[1]

‘There’s a real opportunity for policymakers to set the German economy on a more dynamic path - for example, through higher investment in infrastructure and defence,’ adds Sabrina Reeh, Portfolio Manager for German equities at DWS.^[1]

Optimism for small and mid-cap stocks

If the new German government succeeds in addressing structural challenges and reigniting economic growth, the positive impact could be particularly strong for small and mid-sized companies – more so than for the large DAX-listed firms, which tend to operate globally. This is because small caps generate on average 30 per cent of their profits domestically, compared to only 20 per cent for Dax companies. Accordingly, the forecasts for profit growth are optimistic: ‘The market expects that the profits of MDax companies will grow by 26 per cent this year,’ explains Reeh. The valuation also appears attractive: the price-earnings ratio is just under 14, which is around 20 per cent below the average for the past ten years.

Stability and reform efforts are paying off

Europe is also benefiting from structural tailwinds. While growing political polarisation in the U.S. is creating uncertainty for investors, European governments are focusing on economic stability and reforms. Steps to reduce bureaucracy and lower corporate taxes could further fuel economic momentum in Germany – and generate positive spillover effects for the whole of Europe.

Inflation also appears to be less of a problem in Europe than in the U.S. for the foreseeable future. DWS forecasts inflation rates of 2.3 per cent for both this year and next. With the European Central Bank’s key interest rate at just 2.5 per cent, monetary policy is already positioned to support growth. In contrast, the US key interest rate is currently 4.5 per cent. And if concerns about the US trade tariffs prove justified - pushing prices even higher - there is little reason to expect a shift in policy anytime soon.

Of course, despite all these opportunities, investors should also keep an eye on the possible risks. A sharp downturn in the US economy, unpredictable US trade policy, or further escalation in geopolitical tensions could all trigger increased market volatility. Forecasts are therefore currently subject to a relatively high degree of uncertainty.

Who are Europe's glorious heroes?

Overall the combination of attractive valuations – European equities still trade at a 30 per cent discount to US stocks, despite some narrowing, and the prospect of greater economic stability and structural change make European equities increasingly appealing to investors.

That said, anyone expecting to find US-style technology companies in Europe may be disappointed. Europe's emerging heroes hail from completely different sectors. Sectors such as industrial goods, defence and banking are particularly well positioned to benefit from the impending structural changes, increased government spending and rising investment levels.

Initiatives like the EU Green Deal are also creating long-term growth potential by supporting a wide range of infrastructure and clean energy projects. Low interest rates could particularly benefit cyclically sensitive sectors such as mechanical engineering and chemicals.

European equities are no longer a bargain and will not suddenly become growth rockets across the board. However, the outlook seems solid. Corporate earnings are expected to grow at a mid-single digit rate, complemented by dividend yields of two to three per cent and an additional one per cent from share buybacks. Altogether, this points to potential annual returns of 6.6 per cent over a ten-year horizon. This is significantly less than in the past, but it is above DWS's long-term expectations for US equities of 5.7 per cent.