From Tariff Fears to Earnings Reality: The Expectation Gap in Europe

The market's focus has snapped from global trade to corporate fundamentals. A week of tariff uncertainty ended with a relief note: the U.S. implemented a 10% global rate instead of the higher rate promised. This easing allowed attention to fully turn to the ongoing earnings season, with a busy week of reports from major European names now dominating the agenda.

The pivot is clear. After a positive week in Europe, the initial relief from the lower tariff rate has given way to a more nuanced trading session, with indices like the FTSE and CAC 40 seen opening flat to lower. The core question now is what is priced in. The Stoxx 600 is trading near record highs, a level that implies the market is pricing in a smooth economic recovery and corporate rebound. This setup creates a high bar for the earnings reports to come.

The expectation gap is already forming. While fourth-quarter profits for MSCI Europe constituents have so far exceeded expectations, the market's elevated position means any stumble could trigger a sharp reset. The recent sell-off in U.S. tech stocks, which has left the S&P 500 down almost 30% from its October 2025 peak, contrasts with Europe's resilience. That divergence has drawn investors seeking exposure beyond the U.S. mega-cap tech stocks, but it also means European equities are now the focal point for validating that thesis. The coming week of reports from names like Deutsche Telekom, Allianz, and Rolls-Royce will be scrutinized not just for their own numbers, but for what they signal about the broader economic trajectory the market has already bet on.

The Earnings Print vs. The Whisper Number

The numbers are solid, but the market's reaction is telling. For companies representing 57% of Europe's market cap, fourth-quarter earnings grew 3.9%, a clear beat against the expectation for a contraction of 1.1%. The beat rate is strong at 60%, above the typical 54%. In isolation, that's a positive story. But the muted price action tells the real tale: the good news was already priced in. This is the classic "sell the news" dynamic at work. Analysts note that the net price reaction on the day of earnings has been flat for companies that beat expectations. For those that missed, the move was negative. The reason is straightforward. With the STOXX 600 trading on a multiple of 15.3 times forward earnings, its highest since early 2022, the market is demanding exceptional results to justify those valuations. The current beat, while meaningful, likely met the whisper number that had already been baked into stock prices during the index's run to record highs.

The setup is precarious. Strategists warn that the market is applying elevated valuation multiples to high expectations, particularly for 2026 earnings growth. The expectation gap here isn't about missing a forecast; it's about failing to clear a higher bar. The recent strength of the euro, which has been a headwind, appears to be largely factored in, removing one overhang but not lowering the bar for corporate performance. For the rally to continue, companies need to not just beat estimates, but consistently raise the bar for what's possible. The muted reaction to this quarter's results suggests the market is already skeptical that they will.

Sector Rotation and Guidance Resets

The earnings recovery is not broad-based; it's a story of winners and losers. Banking stocks are leading the charge, with HSBC gaining 7.9% and Santander climbing 4.8% after reporting strong results. This sector strength has been a key driver of the index's record run. In stark contrast, the food and beverages sector was the biggest laggard, a divergence that signals where the real economic pressure points are emerging.

The most telling signal for the future is Diageo's sharp move. The British distiller dropped 10% this week after cutting its guidance for a second time this fiscal year, citing flagging demand in the US and China. This isn't just a one-off disappointment; it's a clear case of a guidance reset that may not be fully priced in. The market's reaction suggests investors are starting to question the durability of consumer demand, a vulnerability that could spread beyond luxury goods.

Strategists see the setup for a pause. A Bloomberg survey shows the median forecast is for the Stoxx Europe 600 to finish 2026 little changed from its recent record high. The expectation gap here is about forward-looking growth. While fourth-quarter profits beat, the market's elevated valuation-near 16 times forward earnings-demands double-digit earnings growth for 2026. That target appears demanding, especially given that EPS revisions have been negative and driven by internationally exposed stocks. The rotation into domestic names and the barbell strategy of cyclical and defensive stocks reflect a search for safety, but they also highlight a lack of broad-based conviction in the economic narrative.

The bottom line is that the easy money from the bank rally may be made. For the index to push higher, the market needs to see a broader inflection in earnings, not just sector-specific beats. The sharp drop in Diageo and the cautious guidance from other consumer-facing names are early red flags that the path to those high expectations is getting steeper.

Valuation and the Path Forward

The market's verdict is in: the current record high is as good as it gets for 2026. A Bloomberg survey of strategists shows the median forecast is for the Stoxx Europe 600 to finish the year little changed from its recent peak. That's a clear statement that the easy money from the rally is made. The expectation gap has flipped from a forward-looking growth miss to a valuation sustainability question. With the index trading near 16 times forward earnings, the bar for justifying that multiple is now set at double-digit earnings growth-a target that appears demanding given the negative EPS revisions for internationally exposed stocks.

The key near-term catalyst is this week's earnings reports from major names like UniCredit and L'Oreal. These are not just company-specific events; they are a test of the recovery's breadth. The recent strength has been heavily skewed toward domestic-oriented sectors like banking, which have benefited from a supportive local economic backdrop. For the rally to have legs beyond a sector rotation, these reports need to show that the earnings inflection is spreading to other parts of the economy. A failure to do so would confirm the market's cautious stance, reinforcing the view that the index's run is over for now.

Watch for any further guidance changes, especially from consumer-facing and export-oriented companies. Diageo's sharp drop after a second guidance cut is a warning sign that the durability of demand is under pressure. The euro's strength, which has been a persistent headwind, appears largely priced in, but it remains a vulnerability for exporters. Any new guidance resets from other large multinationals would signal a potential earnings reset that could pressure the high valuations the market has already assigned. The setup is one of high expectations meeting a reality of selective strength. The path forward depends on whether the coming reports can prove the recovery is broad enough to support the price.