It is no secret that European equities, in aggregate, have significantly underperformed their US counterparts over the last 15 years or so, such that valuations are now extremely low, relative both to history and to other markets, with commensurately modest allocations in most investors’ portfolios.

Given nascent outperformance, many investors are starting to consider whether this is the beginning of a new cycle. The question, therefore, is obvious: will global, US-centric portfolios be fit for purpose going forward, or is now the moment to make some radical re-allocation decisions in favour of European exposure?

Against the backdrop of the US President’s often-bellicose ‘America First’ agenda, it may seem counterintuitive to put forward the conjecture that Donald Trump’s second term in office has the very real potential to be better for Europe than it will be for the US, but I believe there is a strong case to be made that it will be.

In the main, this is because US policy is forcing European policymakers rapidly to do all the things they should have done over the last 15 years, but didn’t. This dynamic will, in my view, fundamentally change the operating environment for many European companies.

Agents of change

Changes are taking numerous forms. Among the most deliberate are the pro-business policy reforms proposed in Mario Draghi’s September 2024 report, The future of European competitiveness, published in a highly co ordinated and choreographed fashion, and with the implicit sponsorship of European Commission President Ursula von der Leyen. What follows is my interpretation of the report’s primary objectives:

1. De-regulation (or, more accurately, pro-competitive regulation as opposed to the pro-consumer regulation of the last 15 years). De-regulation has the potential to be highly beneficial for countless companies, and overwhelmingly supportive of economic growth.

   
   

2. Greater pan-European cooperation in areas such as telecoms, autos and defence, areas in which Europe has large domestic demand, which will stimulate European based global leaders (for example, to create many more Airbus-type companies). Reading between the lines, there is the ambition to take on the US in areas in which it has historically dominated, and develop an environment that engenders technological investments.

   
   

3. Far greater pro-growth fixed asset investment. In the report, Draghi makes the point that we should aim for (and need) 4+% GDP per annum in additional investment, compared to the Marshall Plan of 1948-51 (which was 1-2% GDP) to reverse the multi-decade decline. It is scarcely a leap of imagination to see how an increase of this order of magnitude would have game-changing implications for European companies.

   
   

4. Completion of a full financial union (including the banking union and a capital markets union), allowing for far better financing for this investment and European companies in general.

As a manifesto for change, the report is as important as any in modern European history – and it is not without precedent. Contrary to popular belief, Europe is absolutely capable of transformative change; just as we witnessed in Germany in the 1990s, and again through the structural reform of the peripheral economies against the backdrop of the Eurozone debt crisis (leading Ireland, Greece and Spain to become some of the fastest-growing developed economies in the world), for example, it simply requires the right set of conditions and catalysts. I believe we are once again at a moment of radical transformation.

These policy shifts will not be without consequence. It seems highly probable that they will be accompanied by a de-emphasising of climate- and welfare state-related policies; indeed, empirical evidence to that effect already exists, in the form of decreasing references to these previous priorities in key speeches in the European Parliament. The will and, increasingly, the imperative, to implement change are, however, plain to see.

Electorally, too, President Trump’s actions are exerting an influence with the potential strongly to benefit European businesses, as the realisation dawns on the continent’s centrist political leaders that a continued failure to address European inertia around key topics such as defence runs a very real risk that more politically extreme views will triumph at the ballot box. This has thus become a political existential imperative for European centrists, but it is absolutely driven by the Trump presidency’s demands that Europe take much greater responsibility for its own security.

In defence of European equities

It naturally follows that the upswing in defence expenditure resulting from this recognition has the potential to act as a major stimulus, but not solely for European defence companies. History is littered with examples of conflict-driven innovation, and there is every reason to believe that the present situation will be similarly transformative; there is now a real likelihood that the re-industrialisation of Europe will lead to a marked sharpening of focus on innovation – with contingent benefits for employment and job creation – across a swathe of industries over the coming five to 10 years.

From an investor’s perspective, acceptance that Europe is at a turning point in its modern history begs a question; how best to profit from these changes? I believe that periods of significant disruption and transformation necessitate contrarian thinking, and would argue that simply ‘buying the market’ at this juncture is almost certainly not the answer.

Rather than the large-cap, quality-growth companies that have been favoured over the last decade or so (even in the context of the un-loved European market), the opportunity now is to build a portfolio that emphasises deeply undervalued smaller European companies which have been long out of favour, but which have the potential to benefit meaningfully from reforms, both directly and from any resulting improvement in the operating environment.

Many domestically focused European smaller companies are currently trading on earnings multiples in the low teens (or even lower), and yet our analytical models suggest that there are plenty of these companies that have the potential to grow their earnings at a rate in the region of 15% (or even higher) per annum over the next three to five years.

The shift for many of these businesses from facing headwinds to enjoying tailwinds, combined with undemanding entry valuations, suggests the potential to generate highly attractive returns on a multi-year view. Perhaps most remarkable is how broad based the opportunity set currently is, in terms both of countries and industry sectors. In global terms, given the extremely low starting valuations, such a re-rating still would not push many of these stocks into ‘expensive’ territory.

Those with less contrarian inclinations might, at this juncture, understandably highlight what appear to be a series of headwinds for Europe, resulting from Trump’s unorthodox policies. Given the sabre rattling witnessed towards traditional allies such as Canada and Mexico, we can safely assume that a generous trade deal with the European Union is highly unlikely to materialise, while the imposition of a raft of US tariffs on European exports looks like an absolute certainty.

But here’s the rub. It is precisely because of this new world order, and Europe’s place in it, that these transformations are happening – and this is just the start.

In the medium term, much more important than factors such as tariffs, in my view, is that the substantial withdrawal of US defence capability from Europe – in the process completely upending the defence and security arrangements in place since the end of the Second Word War – now looks like a foregone conclusion. Taken together, it is precisely these developments that are awakening the sleeping giant that is the ‘Old Continent.’

To understand the scale of Europe’s opportunity, it may help to compare it more directly with the US. Europe is home to over half a billion – by global standards, wealthy – people (combining the populations of EU member states with those of other, non-EU European countries, such as the UK and Switzerland), versus under 350 million in the United States. This population disparity notwithstanding, as recently as five years ago, the economies of Europe and of the US were similar in size. The ensuing period of sustained economic growth in the US, coinciding with low or negative growth in Europe has left the US economy decidedly larger.

A much under-appreciated fact is the sustainability of European countries’ debt trajectory. At just over 80% (and falling), aggregate European debt:GDP levels (with funding costs in the region of 3%) look distinctly more supportive than the US’s 115% (and growing) level (source: OECD, Bloomberg). Put simply, Europe has a markedly smaller debt mountain to climb.

To examine these headline figures in isolation, however, would be to ignore Europe’s most important fundamentals; with one of the most highly educated populations on earth, a deeply established rule of law, and a centuries-long history of producing some of the world’s greatest industrial companies. It would be a mistake to imagine that Europe is not capable of successful innovation and reinvention.

Big tech bubble bursting?

In recent decades, the US has risen to prominence as the natural home for ‘big tech,’ while Europe has undoubtedly lagged in this area, largely because the latter has lacked both the infrastructure and environment for these types of businesses to thrive. Naturally, this phenomenon has also been reflected in equity markets, with the individual market capitalisations of the biggest US tech giants (Apple, Microsoft, Nvidia) at times each comfortably outweighing the total market capitalisations of even the largest national equity markets in the European continent.

But study of past events shows us that every market sector – indeed every company – has its day in the sun; a glance at the list of the top constituents of the S&P 500 from 20, 30 or 100 years ago is a salutary reminder of this fact.

Aided by the impetus provided by Trump’s foreign policy, Europe has clearly already discovered the necessary catalyst to create an environment in which its businesses can once again thrive and innovate, just as signs are emerging that America’s tech giants may be starting to face growing headwinds. To put it another way, we might be witnessing simultaneously the autumn of American tech giants, and the spring of unsung, smaller European champions.

To extend that analogy, there is evidence that the buds of a European recovery are already starting to blossom; it has been a very long time since European equities generated aggregate outperformance of their US peers of 10% over a two-month period, and yet that is precisely what has just occurred. Perhaps unsurprisingly, this has not gone unnoticed by some asset allocators.

US tech giants have spent, and are continuing to spend, billions of dollars of capital expenditure on artificial intelligence. They have done this not out of curiosity or altruism, but in the expectation of making a return on those investments. The challenge is that such high-stakes innovation has a habit of flushing out other ways of achieving the same outcome, but at a vastly lower cost.

Just as the economic ambitions mid-19th Century British canal builders were quickly thwarted by the advent of the railways (which were able to transport goods faster and more cheaply than canal boats), so too, I believe, could be those of the giants of Silicon Valley. As the saying goes, history may not repeat, but it certainly does rhyme. Those who ignore parallels from the past do so at their peril.

This possibility was brought recently into sharp relief by the revelation that those behind Deep Seek had achieved, for the cost of a few million dollars, something many had expected to run into the billions. Setting aside for one moment the technical arguments, or those about whether Deep Seek may be purely a plagiaristic copy of Chat GPT, this was, at the very least, an important shot across the bows of the narrowboat of US technological supremacy.

The present scenario, with US equity valuations firmly in ‘bubble’ territory, while shares in many well-run, smaller and medium-sized European companies trade at remarkably undemanding levels, is not entirely without precedent.

It is important to emphasise the characteristics of the European businesses I believe can prosper in this new environment. There is no need to take on an undue degree of investment risk. Specifically, the opportunity now is not in highly speculative stocks (think frontier oil exploration companies), or in businesses whose share prices are supremely discounted on account of deep structural problems (here, Greek banks in 2012, at the height of the peripheral European debt crisis spring to mind).

Rather, the opportunity now presenting itself is to buy good-quality businesses, notably in the industrial and consumer areas, with large market shares, high-quality products, the ability to generate strong returns on equity, and operating in sectors with high barriers to entry, thereby enabling them to preserve their competitive ‘moats’ and to ‘beat the fade,’ at historically low prices. In other words, businesses exhibiting an attractive long-term growth outlook, combined with stability and resilience.

Market technical factors, too, appear supportive. The present catalysts for a reversion in the relative fortunes of European and US equities are as distinctive as President Trump’s modus operandi, but parallels nevertheless exist with previous market cycles. The period from 2003 to 2007 is one recent example. Just as now, by 2001, US equities had become extremely overvalued, leading to a powerful reversion that saw European equities enjoy a strong and prolonged period of outperformance of their US peers.

Fundamentals + valuation + catalyst = lift-off

The conditions appear to be in place for a similar – or possibly greater – reversionary event. Just as the dominance of global markets by the US has become deeply pronounced over the last 15 years, so too has the dominance of growth stocks over value stocks, likewise of large-cap stocks over smaller companies.

This has resulted in asset allocations for many investors that are so strongly skewed in favour of a particular market, and towards a particular investment style and market capitalisation, that a major reversion may have the potential to have a profoundly destructive effect on accumulated returns. There is an opportunity now to exploit all three of these factors in a contrarian way.

As and when a reversion does gather pace, it wouldn’t be outlandish to suggest that the weight and velocity of capital flows out of the US market and into Europe – not to mention from large caps to smaller businesses, and from growth into value – could reasonably be expected to be commensurate with a multi-year cycle in favour of these investment styles.

Although ‘one swallow doesn’t make a summer,’ it is worth pointing out that equity market data from recent weeks already show a marked increase in flows into Europe. Just as occurred when European equities enjoyed a similar revival in popularity in 2013, it isn’t inconceivable that a sudden rush of money into the European market could further underpin stock prices.

Periods of significant change can of course be unnerving for investors, but they often present the most attractive opportunities for long-term value creation. What I have sought to demonstrate in this analysis is why we are now witnessing a confluence of events with the potential to create a significantly more favourable environment for European companies. From a determination at the highest echelons of power within the EU to implement pro-business reforms, to political expediency at the national level, to market technical factors and capital flows, and the scope for a reversion of deep valuation anomalies, the ingredients are in place for a major reversal in the fortunes of European equities.

Combined with the catalyst of President Trump’s apparent determination to upend what had until recently been accepted as global diplomatic and security ‘norms,’ and the case for revisiting European equity allocations could scarcely be stronger. The thought might horrify him, but Donald J Trump could well be the US President who Makes Europe Great Again.