The European stock and bond markets attract global capital as the ideal combination of economic growth and inflation

This year, the European market has been on a strong upward trajectory, breaking previous pessimistic predictions that the Iran war would plunge the region into stagflation.

Since the beginning of the year, the Stoxx Europe 600 Index has risen by 11%, with the benchmark stock indices of Germany, Italy, and France all reaching historical highs. German government bonds have outperformed U.S. Treasuries, while the euro hovers near a two-month high.

Investors are flocking to European stocks and bond markets, benefiting from the best quarterly corporate earnings in four years and continuously improving economic momentum. Although economic growth is accelerating, it remains at a level that does not concern European Central Bank (ECB) policymakers. In particular, some bond funds believe that, in the context of unclear Federal Reserve policy prospects, the European market is more attractive compared to the U.S.

"The economy is at a sweet spot, where there is no need for the ECB to raise interest rates because inflation has not spiraled out of control; at the same time, growth is strong enough to support stock market performance," said Sophie Huynh, portfolio manager at BNP Paribas Asset Management. "We have increased our bullish positions in European stocks because the market still has room for further gains."

According to data compiled from industry research, the profits of MSCI Europe Index constituents grew by 17% year-on-year in the second quarter, marking the largest increase since the end of 2022. Sectors sensitive to economic growth, such as mining and industrial goods, were among the main contributors.

"Investors are indeed attracted by the resilience of corporate earnings," said Helen Jewell, Chief Investment Officer of Fundamental Equities International at BlackRock, noting that Europe's extensive layout in the artificial intelligence supply chain allows investors to "participate in the AI theme in a more diversified and lower-risk manner than in parts of the U.S. and Asian markets."

Bond Fund Inflows

As the economic outlook in Europe improves but still lags behind other major economies, bond investors are also starting to turn to Europe. Compiled data shows that the eurozone's real GDP is expected to grow by 0.8% and 1.2% in 2026 and 2027, respectively, lower than the U.S. growth rates of 2.2% and 2.1% during the same period.

The ECB has raised interest rates by 25 basis points once this year and is expected to raise rates two more times by mid-next year to address inflation shocks caused by the war. However, the growth outlook remains relatively mild, which helps maintain market demand for eurozone bonds, especially as fiscal and policy risks in markets like the U.S. and Japan become increasingly difficult to price.

"European government bonds remain attractive to international investors," said Erik Liem, interest rate strategist at Deutsche Bank. "The ECB has already responded to the Iranian shock, and compared to the Federal Reserve, its policy path is easier for the market to predict, while the Fed's communication direction is changing."

Last week, the yield spread between U.S. 30-year Treasuries and German government bonds widened to its highest level in a year, as investors began to question the credibility of the Federal Reserve and the long-term fiscal outlook for the U.S. Europe also faces fiscal pressures, with elections scheduled in France and Italy next year, but the market currently perceives the associated risks as relatively light.

Attractiveness of the Euro The improvement in demand for European assets is also reflected in the euro exchange rate. The euro reached a seven-week high last Friday and is currently maintaining above 1.15 USD. While part of this is due to the overall weakness of the dollar, Mitsubishi UFJ Financial Group expects the euro to rise to 1.20 USD by mid-next year as global reserve management institutions further diversify their currency allocations.

"The currency that is most worth increasing positions in over the next 12 to 24 months is the euro," said Derek Halpenny, head of research at Mitsubishi UFJ Bank.

However, some market participants remain skeptical about how long the trend of renewed favor for Europe can last.

Duncan Toms, multi-asset strategist at HSBC Holdings, believes that whether the European market can continue to outperform depends on the speed at which investors return to stocks that previously led the AI rally, particularly in the semiconductor sector.

"We believe that the previous momentum adjustment has basically ended. From a relative performance perspective, if the semiconductor sector strengthens again, the difficulty for the European market to continue outperforming will significantly increase," Toms stated