European assets – a deep-dive

Sentiment in European equity markets has been buoyant since the start of the year, supported by increased German and European Union spending plans, prospects for a Ukraine ceasefire, and lower energy prices. If Germany implements its fiscal package, the European economy’s multi-year underperformance could end, gradually closing the gap with the US. This fundamental shift could also translate into better European corporate earnings, although trade uncertainties present hurdles for export-oriented sectors.

Germany’s move to loosen its debt brake could mark a “whatever it takes” moment – akin to the European Central Bank (ECB) commitment to save the eurozone in 2012. Echoing this optimism, European stocks have seen impressive gains and continue to perform well year-to-date. The German DAX is up 15%, and France’s CAC 40 index has gained 9%, primarily driven by defence stocks and banks.

Have European markets moved too far too fast? We think so, and therefore remain cautious on the broader European market near term. Price momentum indicators suggest overbought conditions, particularly in German equity markets. There the legislative process involves two parliamentary chambers, and time is short. Roadblocks in the form of political opposition, or advocates for structural reforms, remain and the risk is that no majority is reached before a 25 March deadline. We believe the amending of the debt brake will go through both chambers, but execution risks will remain near term. As a result, we may see some reversal from current market levels as we enter earnings season again and valuations get contrasted with earnings trends and guidance. Higher costs of capital in Europe will have to factored in as well.

Price momentum indicators suggest overbought conditions, particularly in German equity markets

Valuations in European equities, as measured by price-to-earnings ratios, are in line with historical averages after the sharp revaluation since the beginning of the year. This said, the medium-to-long term relative attractiveness of European versus US equities remains due to more appealing valuations: the price-to-earnings ratios for the European Stoxx 600 index are still lower than those for the US S&P 500 in an historical context. Moreover, fiscal support could boost earnings growth of sectors that directly benefit.

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European luxury and semiconductors look attractive

The luxury sector is benefitting from recovering demand in both the West and China, while the semiconductor industry is a monopolistic industry with recovering demand for analogue chips. We think both sectors offer quality businesses at reasonable value. Indeed the structural valuation premium in both sectors has normalised recently (see chart 1). Finally, the materials sector is supported by planned infrastructure spending and the eventual reconstruction of Ukraine.

Expectations for a higher terminal ECB rate create a favourable environment for the region’s banks, where net interest margins could remain robust, fee income improve, and shareholder returns remain strong. Still, the sector has already risen more than 25% year-to-date, bringing valuations back closer to historical averages. The recent extended gains suggest some caution, with potentially better entry levels ahead.

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Seize higher yields with corporate bonds

A European fiscal expansion would boost long-term growth potential, while inflation data still near target levels reduces the likelihood of aggressive ECB interest rate easing. Therefore, we have raised our Bund yield forecasts, expecting the 2-year bond to reach 2.25% and the 10-year 2.90% over the next 12 months.

Now is a good time for buy-and-hold investors to lock-in more elevated yields

For now, we maintain a portfolio preference for five- to seven-year maturities due to valuation and market timing considerations as yields are currently overextended. The ECB’s terminal rate is 20 basis points (bps) below market expectations, and our fair-value models suggest Bunds are overvalued. Risks such as fiscal expansion challenges, potential US tariffs, and China’s improving credit momentum warrant caution in the very near term. Having said this, now is a good time for buy-and-hold investors to lock-in more elevated yields.

European corporate bonds have outperformed their US counterparts on risk-on sentiment, while concerns about US growth have pressured corporate bonds. Spreads to sovereign bonds have tightened by 15 bps in investment grade (IG) and by 7 bps in high yield (HY) year-to-date¹, closing the gap with still-high US yields. Euro IG and high yield corporate bonds are both well above money market rates. European credit remains attractive, with hedged European IG bonds now offering a yield pickup similar to their US equivalents, while European HY bonds offer higher yields than their US counterparts.

The fundamentals of the credit market remain solid, with contained leverage, strong margins, and low distress levels, though interest coverage is weak. Default rates have risen due to planned restructurings, but are expected to decline. Inflows into European credit continue to outpace the US. If growth expectations hold and yields stay high, we expect inflows to remain strong through 2025. IG corporate bonds have increasingly become an interesting alternative to sovereign bonds, thanks in part to lower yield volatility. The steepening of the yield curve, driven by policy easing expectations and stronger long-term growth, has enhanced the appeal of long duration IG credit as well.

Read also: Staying cautious on European risk assets after Germany’s election

Extended EURUSD, though limited downside

The euro-dollar exchange rate surged above 1.09 in March, reversing a five-month trend that favoured the dollar. But the pair looks overbought, and while potential German growth upgrades could support further gains, these benefits will take time to materialise. Near-term trade uncertainty remains high, especially with the scheduled publication on 2 April of the “America First” trade report. Given these risks, we prefer to remain cautious on EURUSD. Our current EURUSD targets are at 1.06 over both three and 12 months. However, we expect a less negative euro sentiment to be reflected in certain currency pairs. For example, we see the euro appreciating against sterling, as the Bank of England is likely to cut rates more aggressively than the ECB. On the other hand, we see the euro weakening against the Swiss franc, due to strong Swiss external balances. Against the yen, we also see the euro weakening significantly over three and 12 months, as the Bank of Japan normalises policy higher.