The S&P 500 index has experienced its slowest start to the year since 2022, registering a modest gain of just 0.5% from January to the end of May 2025. This stagnation in U.S. equities stands in stark contrast to a notable shift in investor sentiment, as capital flows increasingly favor European markets over traditionally dominant U.S. equities. This trend has raised eyebrows among analysts, particularly in light of various geopolitical developments and economic policies emanating from the U.S.
Investor behavior in recent months suggests a growing disenchantment with U.S. stocks, particularly those belonging to mega-cap companies, which have long been the bellwethers of the market. The emergence of tariff policies introduced during Donald Trump’s administration, along with rising anxieties regarding a potential U.S. recession, are seen as pivotal factors contributing to this malaise. In contrast, European stocks have performed robustly during the same period, suggesting that the market landscape may be evolving in favor of undervalued stocks outside the United States.
According to Marcel Stotzel, co-manager of the Fidelity European Trust, the uncertainty introduced by tariffs has significantly impacted investor sentiment. He remarked, “Trump’s various policy announcements and tariffs have had a profound impact on investor sentiment. While we witnessed substantial passive inflows into Europe at the expense of the U.S. at the start of the year, tariffs have introduced significant uncertainty, particularly as the markets anticipate an economic slowdown in both the U.S. and China.”
This contrast has led to a double-edged benefit for European stocks. Not only have they gained from capital flight, but they are also benefiting from structural improvements within the continent, which some analysts attribute to inadvertent consequences of U.S. policies. Investor George Cooke, manager of Montanaro European Smaller Companies Trust, highlighted that, historically, capital flows had predominantly favored the U.S. market. He noted, “For years, capital flows were largely one-directional: out of Europe into the U.S. However, the resurgence of protectionist rhetoric under the Trump presidency, including the imposition of tariffs on key trading partners, has prompted investors to reconsider the geographic concentration of their portfolios.”
Interestingly, this reconsideration seems to align with certain structural advantages currently present in the European markets. The geopolitical environment is pushing Europe to strengthen its own economic policies, with many analysts suggesting that the continent is witnessing a newfound readiness for cooperation and unity. This shift is manifesting in increased defense spending and infrastructure investments, exemplified by Germany’s decision in March to allocate an additional €500 billion over the next decade.
Jules Bloch, co-manager of JPMorgan European Discovery Trust, described this military expenditure as a transformative move: “This is a really huge change, and that money will be spent mostly inside Europe.” Such spending is expected to invigorate the market and further solidify the position of European companies, particularly in sectors that stand to benefit directly from these investments.
Furthermore, the currently low valuations of European stocks compared to their U.S. counterparts present a compelling case for investors. Bloch elaborated that U.S. stocks, even when excluding prominent tech firms, are trading near historic highs in terms of price-to-earnings (P/E) ratios. Conversely, European stocks, especially small-cap companies, are trading at their lowest valuations in many years. “Europe is actually trading at the largest discount to the U.S. in a very long time,” he remarked, signifying a potential buying opportunity for discerning investors.
The question then arises: which sectors within Europe might experience the most substantial gains? Analysts suggest that the small-cap sector may be particularly well-positioned for growth, largely due to their domestic revenue exposure. According to Bloch, “We know from history that outperformance comes in cycles, and we believe the time has come for European small caps to catch up.” He emphasized that more than half of the revenues generated by European small-cap companies come from domestic markets, which could lead to enhanced performance as European economies strengthen.
The defense sector is also highlighted as a clear beneficiary of this evolving geopolitical landscape. The shifting dynamics of U.S. foreign policy have prompted European nations to reassess their security commitments and defense strategies, leading to increased spending and development in this area. Stotzel articulated the transformative impact of this new approach, stating, “A kick in the backside still moves you forward.” He elaborated that measures, such as the lifting of restrictive fiscal policies in Germany, are now very much on the table, allowing for a more flexible economic strategy that could resonate across the continent.
As investment strategies evolve, financial experts are keen to share their perspectives on the optimal approaches for accessing European markets. The JPMorgan European Discovery Trust primarily targets smaller-cap stocks, which Bloch argues hold significant potential for growth and long-term returns due to their favorable trading factors. The trust is also flexible regarding its investment focus, concentrating on companies that demonstrate the greatest potential for outstanding performance.
Meanwhile, Montanaro European Smaller Companies Trust similarly emphasizes a rigorous screening process to identify promising stock opportunities, focusing on established companies with strong growth attributes and protective barriers. Cooke has underscored their commitment to identifying quality businesses characterized by recurring revenues and a healthy growth trajectory.
The Fidelity European Trust operates on principles of bottom-up stock selection, with its management team asserting a long-term investment horizon in mind. Stotzel stated that their approach prioritizes capital preservation, meaning they take a cautious view regarding macroeconomic factors that could impact their portfolio.
As the U.S. market grapples with its own challenges, including the repercussions of protectionist tariffs and fluctuating growth prospects, the spotlight has increasingly turned toward Europe. With favorable valuations, increased defense spending, and enhanced economic cooperation, the European market is garnering renewed interest as an attractive avenue for investors seeking robust growth.
The ebbing dominance of U.S. equities serves as a stark reminder of the global interconnectedness of financial markets. As investors begin to diversify their portfolios across regions, analysts agree that the loyalty towards U.S. markets may no longer be warranted. Instead, this shift could catalyze new investment trends, setting the stage for European equities to capture market share and deliver value in the months and years ahead.
In light of these developments, stakeholders are urged to maintain a vigilant approach towards market conditions and to consider the potential implications of this regional shift. As geopolitical realities evolve, alongside investor sentiment, European stocks may not only represent an alternative investment opportunity but could also emerge as a cornerstone in portfolios aiming for balanced growth and stability.