European stock markets continued their rally on Friday, with large-cap indices reaching levels unseen in over two decades.
ADVERTISEMENTInvestors are increasingly optimistic about further interest rate cuts by the European Central Bank (ECB) and a stronger-than-expected recovery in China, which has helped counterbalance concerns over economic stagnation and geopolitical risks.
The Euro STOXX 50 index, which tracks the Eurozone’s 50 largest blue-chip companies, gained 0.6% in morning trading, reaching levels last seen in September 2000. It is now poised for a fourth consecutive session of gains.
Germany’s DAX index soared to fresh record highs, defying the broader economic backdrop that saw Europe’s largest economy slip into recession for a second consecutive year. Meanwhile, Italy’s FTSE MIB index also surged to its highest level since late 2007.
Why are European equities rallying despite economic headwinds?
European stock markets are shaking off concerns about a slowing economy, geopolitical tensions, and trade risks, fuelled by several key factors:
- ECB rate cuts on the horizon
With growth stagnating, investors are betting on further interest rate cuts from the European Central Bank.
A 25-basis-point rate cut is already fully priced in for the 30 January ECB meeting, with additional easing expected later in the year.
Lower interest rates tend to boost equities as easing financial conditions for companies may improve their growth.
- Underweight positioning triggers a squeeze
European equities were largely underweighted by investors at the start of 2025.
According to Bank of America’s December 2024 fund manager survey, investor positioning in European stocks was at its most underweight level since 2022, when the region was grappling with the economic fallout of Russia’s invasion of Ukraine.
Relative to US equities, investor allocations to European stocks were at their most underweight since June 2012, at the height of the Eurozone debt crisis.
Such extreme positioning often sets the stage for sharp rebounds, as even slightly positive news can trigger a surge in demand from investors looking to rebalance their portfolios.
- A weaker euro boosts exports
The euro has slipped below $1.03, hitting its lowest level since November 2022.
A weaker euro provides a competitive edge to export-heavy European firms, particularly in sectors like automotive, industrials, and luxury goods.
Since Donald Trump’s victory in the US presidential elections last November, the euro has depreciated by roughly 6% against the dollar.
This depreciation could offset the impact of potential new US tariffs on European goods. If the euro weakens further, it may even neutralise the effects of Trump’s proposed 10% tariff increase on certain European imports.
ADVERTISEMENTAdditionally, the euro has also declined against the Chinese yuan, reaching its lowest level since April 2023. This makes European exports to China more competitive, providing further relief to the continent’s manufacturers.
- China’s economy rebounds faster than expected
One of the biggest surprises for investors has been the strength of China’s economic recovery, which was largely unpriced into European equities.
China’s gross domestic product grew by 5.4% year-on-year in Q4 2024, exceeding both Q3’s 4.6% expansion and market expectations of 5.0%. This marked the strongest annual growth rate in 18 months, fuelled by stimulus measures introduced since September to boost investment and restore confidence.
Industrial output growth hit an 8-month high in December, while retail sales – a key indicator of consumer demand – climbed 3.7% year-on-year, above expectations of 3.5%.
ADVERTISEMENTChina is a crucial export market for European industries, particularly Germany’s automotive sector, luxury brands from France and Italy, and machinery manufacturers. A stronger-than-expected Chinese recovery means higher demand for European goods, giving equities another tailwind.
Looking ahead: Can the rally sustain?
While European equities are riding a wave of optimism, risks remain on the horizon.
Germany’s upcoming general election in February could introduce political uncertainty, potentially affecting market sentiment.
At the same time, energy prices have been rising, with Brent crude up 10% in the past month and natural gas prices surging 40% since mid-September. This poses a challenge for Europe’s energy-dependent industries, particularly in manufacturing and heavy industry.
ADVERTISEMENTGeopolitical tensions also remain a threat, with concerns over potential new US tariffs under Donald Trump’s administration. If tariffs target key European exports such as machinery and pharmaceuticals, they could dampen corporate earnings and weigh on investor sentiment.
Despite these challenges, markets are being supported by the prospect of rate cuts, a weaker euro that enhances export competitiveness, and a stronger-than-expected Chinese recovery.
For now, these factors appear to be providing a solid foundation for European equities, but volatility could resurface if macroeconomic or political risks materialise in the coming months.