(Kitco Commentary) - European stock markets have started the year with impressive momentum. In just over two months, the Stoxx 600 index has gained more than 11%, far outperforming the S&P 500, which has barely gained 1% in the same period. Naturally, this begs the question: what is behind the rally in European stock markets?
At first glance, the obvious answer might be stronger economic growth. However, this theory falls short when we look at the figures. US GDP growth is forecast to be a modest 2.0% this year, while that of the eurozone is expected to be just 0.9%. Clearly, macro fundamentals alone do not explain the rally in European equities.
Could investors be banking on a reduction in geopolitical tensions? A week ago, that might have seemed like a reasonable bet, but peace in Eastern Europe remains elusive after the breakdown of negotiations between Trump and Zelensky on Friday. On top of that, there is the growing threat of a trade war with the United States.
In particular, Trump announced that Europe is next in line after hitting China, Mexico, and Canada with higher tariffs. The European Union has already vowed to retaliate, setting the stage for a trade dispute that could hurt both sides. If anything, this should be a headwind for European stocks, not a reason for their outperformance.
Could political stability within Europe be the driving force? That doesn't seem likely either. Germany still struggles to form a stable coalition government, and its budget problems remain unresolved. Meanwhile, France faces its internal challenges. So, domestic political stability does not seem to be the answer either.
What really fuels optimism?
One crucial factor is monetary policy. The European Central Bank is expected to continue cutting interest rates. At the same time, the Fed has indicated it will hold rates steady for now, partly due to concerns about the inflationary impact of Trump's policies. This divergence could be providing a tailwind for European equities.
Another key driver has been the defense sector, with companies such as Rheinmetall, Leonardo, Thales, and Saab posting strong rallies. Their shares have soared following the weekend meeting of European leaders, where they pledged to increase defense spending as part of a broader peace plan for Ukraine.
How long can this rally last?
That's the big question. With Trump's tariff announcement looming over the market, sentiment could turn negative instantly. Most analysts agree that given the geopolitical risks and sluggish economic growth, the upside potential for European stocks may be limited. However, the reality could be different...