European equities heat up

0:00Patrick Coffey:Welcome back to the Barclays Brief. It's Patrick here. I'm very excited today to be joined by Emmanuel Cau. He's our head of European equity strategy here at Barclays Research. Emmanuel, thanks a lot for joining us today. Hey Patrick, thanks very much for hosting me on the pod. I'm a big fan and it's great to be here. Great. So here we are. It's the 1st of September. Summer is sadly drawing to a close. Investors will be returning from the beach to their Bloomberg terminals. So it felt like a good time to catch up and take stock of where markets stand. Yeah, sounds good, Patrick. Okay. So one of the standout stories this year has been the performance of European equities, which have surprised many investors, given that we have this backdrop of trade tensions, geopolitical uncertainty and question marks around growth.

0:45Patrick Coffey:So Emmanuel, if we were to rewind to the start of the year, few would have maybe predicted the strength we've seen in European equities. What do you think is the single biggest reason for that strength in European equities? Well, you are right, Patrick. It was all about AI and renewed US exceptionalism at the start of the year. And Europe was again of the radar after a brief period of shine during 2025. Somewhat provocatively, we title our European 2026 equity outlook more than just AI on the view that some positives for the region were overlooked by investors. Now, pretty much nine months into 2026, Europe and equities are performing pretty much in line with the US, up even 20%.

1:27And I don't think Europe's good showing is actually due to one particular factor, but rather a number of tailwinds coming up together. Improving market breadth and investors looking for portfolio diversification beyond big tech has definitely helped Europe, particularly in recent months, where we saw a sharp unwind of momentum trades, investors realize that US and many Asian equity indices are predominantly driven by tech. So they are all moving closely together, basically, while Europe is less correlated to the AI narrative. At the same time, it's fair to say that the resilience of European growth has surprised many, including ourselves.

2:06And this is despite the energy squeeze coming from the war in Iran. And like in the US, Europe is entering a manufacturing and investment boom, which has led to a strong earnings recovery in 2026 after three years of stagnation. And finally, we are seeing a broad value side revival with commodity sectors and banks, which is key sector in Europe, strongly outperforming. And as I always say, Patrick, if banks are fine, Europe is fine.

2:33Patrick Coffey:Okay, so diversification, resilience of growth, and that sort of value style revival you talked about have been key to this European strength. But another theme that we talk about when we catch up is about the difference between earnings growth and the re-rating. So are we now entering a phase where earnings growth has to take over from valuation expansion to keep these European stocks going up? Well, maybe I should have been a bit more nuanced here, Patrick, because multiples have run-related that much this year and do not look that extended. In fact, European equities have largely performed in line with strong earnings.

3:13But yes, in the current regime of higher for longer range, which, by the way, of fixed income strategists expect to continue, it is hard to see valuations doing the heavy lifting. Although, as long as yields are going up for the right reason, it should not be a constraint on valuation. But yes, we are working a fine line here, given all the moving parts, with fiscal dominance and higher term premia becoming a bigger contributor to the rising yields. So it is very much earnings that matter for equities. And regarding the longevity of the cycle, we are fairly optimistic. Growth indicators remain well-oriented, particularly in manufacturing and in Germany.

3:50Base effects from a year ago are turning more favorable as the drag from tariff and the strong euro are dissipating. All prices high, but not too high. So energy earnings are going up without hurting other sectors. And we are seeing emerging evidence of AI capex driving productivity higher and lifting margins for some sectors. And finally, higher rates are also a positive for banks' earnings, which is one of the biggest contributors to earnings growth for the overall market in Europe.

4:21Patrick Coffey:Well, let's dig into the rates, because obviously that is the topic du jour. Investors often assume that higher yields are bad news for equities. You have typically argued the relationship is just a bit more nuanced than that. So what matters more for stocks right now? Is it where rates are or why rates are moving? Well, you should always take equity strategies view on rates with a pinch of salt, Patrick. And these days, everybody seems to have become a fixed income expert. But all work showed that the reason for the moving yields and the speed of the move typically matter more for equities than the actual level of yields.

4:57And right now, bond investors are mostly concerned about the fiscal dominance, which is weakening central banks inflation fighting credibility. And that's why the term premia have gone up across the board, as most developed economies are running massive deficits without a strong commitment to improve fiscal trajectory. But while this is a fair concern, the rise in yields we have seen in the post-pandemic era has been coming with a strong rebound in nominal growth. And all this fiscal spending basically is pushing up growth and inflation, which is feeding into strong earnings. So basically, some inflation, as long as it is under control, is not a bad thing for equities.

5:38But as we have seen most recently, equities have become again more sensitive to interest rate volatility. So we are probably near the danger zone here for equities.

5:49Patrick Coffey:Okay, so we're near the danger zone, but I like what you said and the work you've done around the speed in the move of yields mattering more than the actual level of yields for European equities. Let's pivot now and think about the US versus Europe. Now, it's a typical question. I know you get asked it all the time, but Europe seems to benefit as a bit of an anti-AI trade. So if you're pitching European equities to a global investor today, what do you think is the strongest argument for them owning more European equities rather than simply buying more American equities? Well, let's be clear here.

6:22US equities weight almost two thirds of the global equity market cap. So they will always be the dominant share of any global investor portfolios. And European investors typically feel like they are in the passenger seat, as it is the U.S. that is driving the show. And believe me, Patrick, I know the frustration. Now, once you accept that, you can still find some reasons not to dismiss Europe. And you're right. There is certainly an anti-tech angle here, as Europe is less of a direct proxy for the AI narrative than the U.S. and many other Asian indices like Korea or Japan. But a lot of the capex revival in Europe is ultimately driven by the global AI investment boom.

7:02And then we have seen recently the debasement trade hitting the dollar, which means that equity flows are starting to broaden out. And a strong currency makes Europe equities a bit more attractive to U.S. investors. And equally, a weaker dollar makes U.S. equities less attractive to foreigners. And then you have a valuation argument, which is relevant in a world of higher for longer rates, as Europe is more value-oriented and thus less rate sensitive than the US. And finally, we speak to many active managers who are struggling to cope with a very high concentration of the US indices while market breadth is wider in Europe.

7:39Patrick Coffey:Yeah, I mean, I think I totally understand why investors would want that diversification angle of Europe. But what do you think has to happen for Europe's strong performance to continue over the next 12 months? Well, first, I think it's all about earnings. we need to see, Patrick, a continuation of the earnings subcycle, given there are still many European septic investors out there who still see Europe as a value trap, i.e. cheap but for good reason. And Q2 earnings in Europe are very strong, right? Indeed. We had a very strong Q1 and Q2, so that's giving a hope that there is momentum into the remainder of the year.

8:14And I think here, obviously, some stabilization in oil is important and the kind of continued resilience of growth is also obviously key. And here I think progress on German stimulus is quite important for sentiment in Europe. You know, we are seeing more and more green shots emerging in Germany. But of course, we are still early days in terms of implementation and there is pretty high execution risk. I guess finally, a less tech-heavy market would be helping too. I'm not saying, Patrick, you have to be bare on AI to be bull on Europe, But there will be a lot of fresh capital driven by AI-related issuers that has to be absorbed in the US, both by the equity market and the debt market, which is less the case in Europe.

8:55Patrick Coffey:Okay, so we put it all together. You've been pretty constructive on Europe for a while now, and been right. I'm sure you get asked this a lot by investors, but what do you think is the biggest reason the European equity story could unravel from here? You know, when you do my job, Patrick, as a European equity strategist, the first question you have to be prepared to answer from clients is what could go wrong with Europe. And indeed, the list is quite long. In the near term, I think the main concerns revolve around deficits, although it's not really specific to Europe, politics and geopolitics.

9:26France will be a key focus point for markets into the 2027 presidential election with negotiations on the budget starting soon. I think a lot is priced in and known already, but the noise won't go away. Germany also has three important local elections in September. The conflict between Ukraine and Russia, US and Iran are wild cards, and gas prices have gone up again for Europe, and inventories are quite low into the winter season. And finally, China remains a key market for many European exporters and a growing source of competition at home. So growth and policy development there are very important to monitor as well.

10:06Patrick Coffey:Okay, so if you're thinking about how to trade this backdrop then, so if we move away from well-known European sectors, you talked about banks quite a few times, which sectors do you think investors are beginning to warm up to that maybe our listeners would be interested in? Look, I think, Patrick, the market is quite polarised. I think financials, banks and industrials are quite consensus and have been strongly outperforming. On the other hand, there is a lot of aversion for the consumer discretionary, consumer status. I mean, very poor performers. We are starting to see some incoming on that, but still very little interest overall.

10:41One area of emerging appetite seems to be commodities. I think in the backdrop of weaker dollar and still resilient growth and inflation risk, people are looking for a trade that could give them a bit of a hedge here. And we are placing a bit more interest on the commodity space right now.

10:55Patrick Coffey:Yeah, it's interesting. that commodity space is actually something we've talked a lot about on previous episodes of this podcast. So listeners should go back and check some of those out. Emmanuel, thanks a lot for joining me today. It's been great to catch up. Thanks for having me, Patrick. Okay, so while European equities may have started the year as being a little bit overlooked, I think Emmanuel today is arguing that those European equities are now benefiting from a combination of stronger earnings, broader market leadership, and an improving economic momentum. And it's not just about being an anti-AI trade.

11:30Patrick Coffey:The challenge from here, however, is proving that this recovery has further left to run. Thanks a lot for listening to the Barclays Brief. If you liked today's conversation, do hit subscribe and we'll be back at the same time next week.