European stock markets are emerging as significant beneficiaries amid a global shift of capital away from crowded AI and tech stocks into broader sectors.
The Stoxx Europe 600 Index rose 0.7% to close at 652.77 points on Friday, July 3, after hitting a record intraday high of 652.35, marking its fourth consecutive weekly gain and the largest weekly advance since mid-May.
Germany's DAX index also reached a new all-time high, closing up 0.8%. This record-setting rally is being driven by an accelerating sector rotation, with cyclical sectors such as healthcare, personal care, food & beverage, finance, and defense taking the lead.
This shift comes as the previously high-flying technology sector experiences a phase of consolidation. "As investors look beyond the AI leaders to sectors supported by structural growth, policy tailwinds, and improving cyclical prospects, there is room for this rally to broaden," stated Mark Haefele, Chief Investment Officer at UBS Global Wealth Management.
The European Advantage: Low AI Exposure and Valuation Support
In contrast to the US market, where technology stocks hold a weighting of approximately 30%, the tech sector represents only about 8% of the Stoxx 600 Index, a figure also lower than in Asian markets.
This structural disparity has granted European markets a notable "immunity advantage" during the recent volatility in AI-related trades. "European indices with lower technology weightings are back in favour, not least because these stocks are trading on valuations that are far lower than their US counterparts. So, not only is there less exposure to the AI trade in Europe, but it is also relatively cheap," noted David Morrison, Senior Market Analyst at Trade Nation.
Data for the first half of the year shows the Stoxx Europe 600 Technology Index gained 23.4%, outperforming the S&P 500 Information Technology Index's 19.4% rise.
The broader Stoxx 600 rose over 8% in H1, with the UK's FTSE 100 up 5.7%, Germany's DAX gaining about 1.9%, and France's CAC 40 advancing around 3%.
However, Europe's reliance on tech stocks is not negligible. AI-related companies like ASML, Infineon, and ABB accounted for 9 of the top 20 contributors to the Stoxx 600's gains this year, collectively responsible for 47% of the index's rise. This means Europe is not immune to risks should the AI theme falter.
Macroeconomic Tailwinds: Cooling Inflation and Diverging Policies
The rally in European markets is underpinned by improving macroeconomic fundamentals. On inflation, the Eurozone's rate fell sharply to 2.8% in June from 3.2% in May, coming in below economists' expectations of 3.0%.
ECB President Christine Lagarde stated that the risks of upside inflation and downside growth are "more balanced than a few weeks ago." "The tone from policymakers is clearly less hawkish than in June... The central bank is becoming more comfortable with the inflation path," observed Modupe Adegbembo, an economist at Jefferies.
Policy paths are diverging between the ECB and the Federal Reserve. European officials have repeatedly emphasized that further rate hikes are far from certain.
Since the ceasefire in Iran, rate markets have adjusted significantly, with expectations for a full rate hike over the next 12 months now near zero, compared to nearly three hikes a month ago. LSEG data shows traders currently price in about 23 basis points of ECB rate cuts this year.
In contrast, robust US growth has driven a hawkish repricing of Fed expectations, significantly pushing up real yields and the US dollar. On the fiscal front in Germany, Chancellor Merkel unveiled the country's largest reform package in decades, encompassing 34 measures including tax cuts (approximately €10 billion annually), raising the retirement age from 67 to 70, easing corporate layoff restrictions, and significantly streamlining bureaucracy.
Analysts believe these reforms will ultimately boost Eurozone domestic demand growth.
Outlook: How Long Can Europe's 'Mini Goldilocks Moment' Last?
Bank of America strategists describe the current European market environment as a "mini Goldilocks moment," characterized by resilient growth, continued disinflation, and a markedly less hawkish ECB. Consequently, they favor domestic European stocks, small-caps, and German equities.
However, the sustainability of this "perfect state" faces challenges. Europe's reliance on AI-related stocks—with 47% of index gains coming from just nine such stocks—means the region is vulnerable to a broader reversal in the global AI trade.
Barclays notes that volatility in tech stocks and Fed sentiment has already impacted momentum trades, and Q2 earnings will be a key test. Trade Nation's Morrison cautions that Europe's valuation advantage may erode with continued gains.
Amid the persistent policy divergence between the ECB and the Fed, Eurozone domestic demand growth could accelerate towards year-end. But as BofA warns, "European markets remain perfectly priced," and any surprise could disrupt this fragile balance.
Bank of America: Raises Target but Warns of 'Perfect Pricing'
Bank of America has raised its year-end target for the Stoxx 600 to 630 from 590, citing eased energy shock pressures in the Eurozone, increased German fiscal support, and an ECB closer to cutting than hiking rates.
Nonetheless, BofA strategist Sebastian Raedler maintains an 'underweight' rating on European equities. "Despite a more optimistic growth outlook for the Eurozone, we remain negative on European equities—European markets remain perfectly priced, with margin expectations at record highs and risk premiums at 20-year lows," he wrote.
BofA expects the Stoxx 600 could pull back to around 595 in early Q4, influenced by high valuations, a potential slowdown in AI-driven market momentum, and rising credit risk.
Barclays: Diversification Trade Accelerating
A team led by Barclays strategist Emmanuel Cau points out that uncertainty around tech stocks and Fed policy is hitting momentum trades. With positioning games dominating, Q2 earnings are crucial for re-anchoring prices to fundamentals.
Barclays believes Europe would outperform the US in a significant tech sell-off, but further diversification into defensive sectors "makes a lot of sense." Hedge funds and Commodity Trading Advisors have begun rebuilding European equity positions, benefiting from falling oil prices and broader diversification beyond AI.
Barclays previously raised its Stoxx 600 target by 50 points to 670, placing it alongside HSBC as one of the most bullish banks on European equities.
Morgan Stanley: Investors Eager to Broaden Horizons
Morgan Stanley's Chief European Equity Strategist, Marina Zavolock, stated that Europe offers ample scope for diversification, with improving fundamentals and structurally rising stock dispersion.
She recommends increasing exposure to bank stocks while cautioning that selectivity is required in other sectors. Morgan Stanley notes that while nearly 70% of European long-only funds are overweight chipmakers and will continue to favor AI capex beneficiaries, a prudent strategy should also include heavyweight names from outside the sector.
The bank's recommended stocks include Airbus, Saint-Gobain, Inditex, Richemont, AstraZeneca, and British American Tobacco.
Goldman Sachs: Shifting to Defensive Sectors and European Defense
In its latest strategy note, Goldman Sachs indicated that the momentum behind the US AI rally is showing signs of exhaustion, with a potential "summer lull" in July. Against the backdrop of capital rotation from high to low, Goldman strongly advises investors to shift towards defensive sectors and "non-AI related" investment targets in the second half, with healthcare being its top pick.
A basket of European defense stocks compiled by Goldman Sachs rose 6.4% last week. With ongoing geopolitical tensions, investors anticipate further increases in defense spending.
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