European Stocks: A Hidden Gem in April 2025?

European equity markets have been on a tear in 2025, outperforming their US counterparts by a significant margin. As of April 11, 2025, the MSCI Europe Index has risen roughly 9%, handily beating the S&P 500’s roughly 0.5% gain. This is Europe’s strongest relative start to a year since 2000 and a marked contrast to its lackluster past decade. But the question on everyone's mind is: will this rally continue, or is it time to take profits?

The rally in European equities this year has had the effect of pushing up valuations, bringing them even closer to our fair value estimate than last quarter. As things stand, the European market is trading just 2% below our fair value estimate. So investors shouldn’t be expecting another big rally in the coming months. However, there are several factors that suggest European stocks may still be undervalued.

First, let's consider the macroeconomic conditions. European inflation sits at just 2.2%, the lowest level in the western world, putting us within reach of the European Central Bank’s 2% target. This low inflation rate is favorable for economic stability and growth, which can positively impact stock valuations. Additionally, interest rates in Europe have been cut to 2.5%, with forecasts pointing to another 50 basis points of cuts by the end of the year. This compares favorably to the US, where rates are still at 4.5%. Lower interest rates make borrowing cheaper for companies, which can boost their profitability and, consequently, their stock prices. Furthermore, lower interest rates can make dividends more attractive relative to government bonds, potentially driving up demand for stocks.



Second, let's look at the German infrastructure and defense spending package. The German infrastructure package, which includes an extra EUR 500 billion in spending, is expected to spread further across Europe, stimulating economic activity. This is comparable to the US Inflation Reduction Act, which was worth $900 billion (EUR 741 billion), but spread out across a much larger economy and population. The increased spending is likely to narrow the GDP growth gap between Europe and the US, with Vanguard forecasting Europe growing at 1.6% in 2025, just 10 basis points shy of their US forecast.

The defense spending increase is not a short- or medium-term phenomenon. Morningstar analysts are forecasting spending of around 3% of GDP out past 2032. This long-term commitment to defense spending is expected to benefit defense companies significantly. For instance, Rheinmetall RHM shares have already risen by 120% in 2025, and the fair value estimate has been raised to EUR 2,200, implying an upside of two-thirds from the current share price.

The German infrastructure package could also boost the automotive sector. Auto makers have long complained that underfunded infrastructure has been holding them back. Changes in infrastructure spending could be a catalyst for the sector, potentially moving the needle back into positive territory for stocks like Volkswagen VOW3.

Lower interest rates in Europe, which have been cut to 2.5% and are expected to be cut by another 50 basis points by the end of the year, should boost consumer spending. This, combined with lower inflation, could ease input cost pressure on consumer goods firms, making valuations in sub-sectors like brewers and distillers more attractive.

The regulatory environment in parts of Europe, particularly in Spain and Germany, is improving. Lower interest rates in the second quarter should benefit utilities stocks in two ways: lower debt payments and more attractive dividends relative to government bonds.

In summary, while European stocks may not be as undervalued as they were at the start of the year, there are still several factors that suggest they may be a good investment. The low inflation and interest rates, combined with the German infrastructure and defense spending package, could provide a significant boost to European economic growth and stock market performance. However, investors should be cautious and keep an eye on the potential risks, such as the possibility of a multi-generational shift in American foreign allegiances and the potential for increased volatility in the stock market.