Investors are questioning US exceptionalism and the continued outperformance of its financial markets. US stocks have underperformed the rest of the world since the start of the year by the widest margin since 1993. The catalyst for the underperformance is Trump’s trade policy shock, which is hurting the US economy more than its trading partners, evidenced by the impact on surging inflation expectations, rising Treasury bond yields, falling stock prices and a sharp dollar depreciation.

At the same time, Europe has made big stock market gains. The catalyst is the momentous policy shift in Germany, which contributes just under a third of eurozone GDP. There has been a seismic shift from Germany’s traditionally conservative and debt averse fiscal policy, with significant consequences for economic stimulus. The new coalition government has agreed to reform the so-called “debt brake,” the strict constitutional fiscal rule that prevents the government’s core budget deficit from exceeding 0.35% of GDP. Defence spending exceeding 1% of GDP will be exempt from the rule, as will a deficit financed fund for infrastructure worth €500 billion, equivalent to 12% of GDP.

Germany has suffered the longest economic slump in its postwar history, which together with increasingly isolationist policies in the US is prompting dramatic action. Germany is embarking on supply-side structural reforms, which like the US and UK in the 1980s under Ronald Reagan and Margaret Thatcher, could kick-start a prolonged period of improved growth. Newly elected Chancellor Friedrich Merz in his “whatever it takes” plan, has vowed to reinvigorate the economy with debt fuelled spending on infrastructure and defence, tax subsidies for investment, and deregulation. Economists are expecting as much as €1 trillion in additional domestic spending in the next decade, equal to well over a fifth of GDP. This is good news: The scale of reforms is large and focused on areas of strategic importance. The poor state of Germany’s infrastructure has been a key factor holding back its growth in recent years. Benefits will spill over into the rest of the eurozone through increased trade as well as more lenient views towards fiscal spending and supply-side reforms. This is likely to be a game changer not just for Germany but for Europe.

The eurozone is also enjoying a cyclical recovery. Economic data in the region has been surprising to the upside. The eurozone economy grew in the first quarter of the year by 0.4% quarter-on-quarter up from 0.2% in the prior quarter, outpacing the US for the first time in almost 3 years. The US economy contracted on an annualised basis by 0.3% while by the same metric the eurozone economy grew by 1.4%. Meanwhile, eurozone unemployment remained at record low levels, staying at 6.2%. A key challenge to the eurozone has been a reluctance by consumers to spend but the cyclical and structural recovery is boosting consumer confidence. Households have been abnormally cautious this decade, building up a €1 trillion stockpile in accumulated excess savings, which could be unleashed if the recent improvement in consumer confidence and retail sales volumes continues to build momentum. Like other developed economies, household spending comprises the bulk of the eurozone’s economy.

Over the short-term, Germany’s GDP growth will slow due to uncertainty over US trade policy. The IMF, in its latest projection, forecasts zero growth in 2025. Even a slight recession is possible but fiscal stimulus, massive increases in spending on defence and infrastructure, and increased investment and consumer spending could create a solid foundation for subsequent growth. Unlike the US, where trade tariffs are inflationary, in the eurozone, the trade war is disinflationary, provided, as seems likely, the eurozone does not retaliate. A stronger euro, the increase in Chinese imports and the recent drop in natural gas and oil prices, add to the region’s favourable inflation outlook. This paves the way for more interest rate cuts than expected. The ECB is on track to cut its benchmark interest rate from its current level of 2.25% to 1.5% by the end of the year. By contrast, the Federal Reserve will be hamstrung by rising inflation expectations. At its latest policy meeting the ECB cut its interest rate and Christine Lagarde said the central bank was on track to meet its inflation target “on a sustained basis.” At the Fed’s latest meeting, when rates were kept on hold (much to Trump’s frustration), Jerome Powell said he needed to “wait for greater clarity.”

Valuations in Europe are compelling. After years of investor scepticism towards the region, stock prices have become deeply discounted. Eurozone stocks trade at 25% cheaper than the global market on a relative price: earnings basis and 40% cheaper on a cyclically adjusted P/E basis, its widest discount in several decades. The valuation disparity seems at odds with the steadily improving profit margins and return on equity of key financial and industrial sectors. Moreover, the euro currency is cheap relative to the US dollar, undervalued by an estimated 20% according to various models, including real effective exchange rates and the purchasing power parity model, providing scope for further appreciation as the currency benefits from improving relative growth conditions, and a general exodus from the US dollar.

Markets have taken the view that the historic fiscal shift in Germany is a game changer for economic growth in both Germany and Europe. Structural reforms have finally arrived, combining with a cyclical upturn, rising company profitability, and massive household spending power. Cheap valuations and a pendulum swing away from US markets add to the likelihood of eurozone market outperformance. Overberg Asset Management has recently increased its global portfolio exposure to European stocks.