As global investors seek to trim their exposure to artificial intelligence (AI), Europe's diversified stock market has suddenly become one of the most attractive trades.
Not long ago, the European STOXX 600 Index was still lagging behind, with the market wary of its vulnerability to rising oil prices and its lack of leading tech stocks in the AI wave.
Now, Europe's combination of solid industrial stocks, bank stocks, defensive leaders, and a host of commodity companies is highlighting its value.
On Thursday, the STOXX 600 Index withstood the deepest pullback in the S&P 500 since April 2025, and is on track to post its strongest quarterly excess return relative to global stocks since early last year, when Germany first announced a large-scale fiscal stimulus plan.
"Given the policy stalemate, this indiscriminate selling in the market has been excessive, though it will take time for sentiment to stabilize. Europe is relatively well-positioned to benefit, especially if the tail risk from oil prices fades," said Emmanuel Cau, head of European and Asia-Pacific equity strategy.
In fact, even before the U.S. midterm elections, Europe's strong earnings growth was already matching the performance of its peers across the Atlantic, enhancing its appeal. But as a Democratic sweep of Congress intensified concerns about the risks of the AI trade, investors urgently needed to change course.
Europe has become the destination of choice for capital. The "blue wave" set off by American voters drove U.S. Treasuries higher as the market bet that Democrats would constrain the Trump administration's tax and spending plans. This also revived the outlook for many clean energy stocks listed in Europe.
A shift toward defensive sectors initially provided the main thrust, but recently the entire market has been rising. This stands in sharp contrast to the market characteristics of the past five years, and lays the foundation for the index to close higher in 2026.
"In October, the market favored low-volatility bond substitutes such as healthcare and food and beverage, but investors are now chasing cyclical stocks more sensitive to falling interest rates," said strategists at Kepler Cheuvreux led by Arnaud Girod. "This could help spark a year-end rally."
The midterm elections cleared the way for the market. This week's plunge in oil prices indicates that investors have begun to price in a higher probability that the Iran war will end soon. Sectors that suffered the most profit-taking in recent months, such as banks and mining, as well as consumer discretionary stocks that have lagged this year, are all getting some breathing room.
That said, risks remain in the region. The recent surge in bond yields and credit spreads is still fresh in investors' memories, and the political situation in France ahead of the April presidential election remains worrisome. Meanwhile, if oil prices decline, strong earnings growth may be called into question. In addition, the region's economic growth rate next year may remain sluggish at 1.3%, compared with 2.2% for the U.S. and 3.3% globally. But that may still be enough to support a stronger market.
"We find that the impact of global sentiment is more important than purely domestic growth," said Goldman Sachs strategists including Sharon Bell. "More than half of the STOXX 600 Index's revenue comes from outside Europe."
Earnings growth is the biggest surprise. The market had previously expected European earnings to accelerate steadily, catching up with the gradually slowing U.S. profit growth by 2027 or 2028. But Europe's recovery has been much faster than expected. Third-quarter reports show that European corporate profits have rebounded sharply, with momentum strong enough to match U.S. stocks. Earnings per share growth in both regions was about 32% year-on-year, but Europe's earnings beat expectations by 9.2 percentage points, higher than the U.S. figure of 7.6 percentage points.
"Europe delivered another strong quarter of earnings, reinforcing our view that the region's profit recovery remains on track," said Matthew Gilman, head of European equity strategy in the chief investment office at UBS Global Wealth Management. "Revenue growth continues to pick up, margins continue to recover, and earnings revisions are above the seasonal norm."
Gilman said that although investment-related demand remains the main engine of growth, supported by AI, electrification and defense spending, earnings improvement is spreading to other areas. "Therefore, we believe the earnings outlook is more structurally balanced and no longer overly dependent on a few tracks."
Admittedly, energy stocks accounted for a large part of last quarter's growth, but profits rose in every sector. Moreover, although falling oil prices will erode index-level earnings per share, their positive impact on market sentiment may continue to lift stock prices. Lower energy costs will also ease the burden on consumers and could slow the pace of interest rate hikes by the European Central Bank or the Bank of England.
In the short term, signs of an overheated market have emerged, with nine industries already in overbought territory. However, the broad index has not yet shown similar signals, and foreign investors' overall allocation to Europe remains low. A Bank of America fund manager survey last month showed that global investors still maintained an 8% underweight in Europe, meaning there is room for further capital rotation.
"We have clearly shifted to a risk-on mode," said Florian Roger, head of the chief investment office at BNP Paribas Corporate and Institutional Banking. "We are overweight Europe and believe several sectors could drive further gains."
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