European stock markets surge as US stock market sags

We’ve seen a big change in market performance thus far in 2025. The MSCI USA Index, which returned 23.4% last year, has gained just 1.22% so far this year.¹ Conversely, European indexes have seen strong relative returns so far this year after modest gains last year.¹ For example, the MSCI France Index, which actually had a negative return last year, has posted a double-digit gain so far this year.¹ So what’s behind this trend? As I’ve mentioned before, there have been four key drivers of European equity outperformance:

• Monetary policy in the eurozone is expected to be more accommodative than monetary policy in the US going forward.
• As indicated by the Citi Economic Surprise Indexes, there has been positive economic surprise in the eurozone and negative economic surprise in the US.
• Earnings momentum, while negative, has been improving in the eurozone while earnings momentum in the US hasn’t.
• Valuations are relatively low in the eurozone but very high — essentially priced for perfection or close to perfection — in the US.

Germany plans substantial increase in defense and infrastructure spending

Adding to these four factors, Germany made a momentous announcement last week – one that marks an extremely important shift in the world from both a political and economic standpoint. Incoming Chancellor Friedrich Merz announced plans to increase defense and infrastructure spending substantially. This is a 180-degree change for a country that has been laser-focused on maintaining fiscal prudence — to the detriment of its economy in recent years. But that’s no longer the case.

The new German governing coalition plans to dramatically alter the country’s cap on deficit spending in order to spend up to €1 trillion on defense and infrastructure over the coming decade.² While this is being done in reaction to US policies, it offers compelling economic benefits for Germany, addressing key issues facing its economy. German manufacturing has been in the doldrums for the last several years. Last year, I received dozens of questions from skeptical clients asking if Germany would ever see a restoration of its former strength in manufacturing. But few envisioned how quickly relations between the US and Europe would deteriorate and how quickly Germany and other European nations would respond.

And it’s not just Germany; many European nations have been catalyzed by the US shift away from its longstanding allies. This week, European Union (EU) leaders are expected to hold emergency talks on Thursday to decide upon ways to lift EU-level fiscal constraints in order to quickly increase their military budgets. European countries are acting rapidly and dramatically, and markets understand this is an important shift — the most seismic development since German reunification. I think it’s no coincidence that Mr. Merz used the language “whatever it takes,” channeling his inner Mario Draghi. Not surprisingly, last week, the yield on the 10-year German bund rose as high as 30 basis points — the largest jump since 1990.¹

US is prioritizing government spending cuts

Meanwhile, the US seems to be dramatically reducing spending through its Department of Government Efficiency (DOGE) effort. While markets seem focused on tariffs, I believe dramatic government spending cuts are the bigger threat to the US economy. While the US certainly needs to trim spending to reduce the fiscal deficit, I think very few anticipated that cuts would be so swift and aggressive. This can be very problematic for the US economy because every lost job and every dollar of reduced spending has implications for the overall economy.

I think of it as a potent “reverse multiplier effect” — removing a dollar of government spending has ripple effects, reducing spending throughout the economy. The amount of the impact depends on the kind of government spending that’s being cut. Cutting areas of government spending that have higher multiplier effects — for example, transfer payments to low-income households — will have a more negative impact on the economy than cutting areas of government spending with lower multiplier effects. Transfer payments have a higher multiplier effect because low-income households are more likely to spend every dollar they receive rather than save some of it. In other words, all else being equal, cutting payments to low-income households should have a bigger impact on the US economy than, for example, cutting taxes for higher-income households that are more likely to save part of that money. We need to pay close attention closely to where the cuts are occurring, not just that cuts are being made.

Probability of a US recession has risen

So, the switch in Europe/US stock market performance is likely to be amplified by the switch in fiscal impulse. And that switch in fiscal impulse has substantially increased the probability of a US recession this year.

The Atlanta Fed GDPNow indicator is showing an alarming pullback in US economic growth for the first quarter, now expected to be -2.8% (although it will certainly be revised many more times before the end of the quarter).³

Government spending cuts are already having an impact on employment. Challenger, Gray & Christmas announced last week that job cuts from US employers increased 245% in February to 172,017 — the highest level since July 2020 when America was in throes of the COVID-19 shutdown.⁴

And we shouldn’t overlook the feedback from the Federal Reserve Beige Book released last week:⁵

“Contacts noted sharply higher uncertainty around the outlook, with a wait-and-see stance echoed widely. Reduced labor supply as a result of stricter immigration policy, increased costs from tariffs, and decreased government spending were cited as headwinds for economic activity, while potential deregulation and corporate tax cuts were seen as tailwinds.”

“Contacts in manufacturing, ranging from petrochemical products to office equipment, expressed concerns over the potential impact of looming trade policy changes.”

“Some contacts in the sector also expressed nervousness around the impact of potential tariffs on the price of lumber and other materials.”   

“A few contacts were hesitant to hire because of uncertainty about how federal government policy changes could affect the economy.”

“Business and group travel volumes fell notably, with one hospitality contact in Southern California reporting a number of business trip cancellations from groups impacted by recent changes to federal government funding.”

Will this trend continue?

While the odds of a recession have greatly increased, we don’t have enough information to know whether or not the US economy will go into recession. Much will depend on the extent of government spending cuts going forward. Recession is not a fait accompli — yet.

Having said that, I think European stock market outperformance versus US stocks is likely to continue this year. I believe a key driver going forward will be the change in fiscal impulse for the markets’ respective economies. We’ll stay tuned.

Looking ahead

The Bank of Canada will meet this week and decide on whether to cut interest rates again. Current US government funding ends on March 14 and must be extended by a politically fractured US Congress, which could result in a government shutdown — and of course short-term uncertainty and volatility. Also, we’ll closely follow European leaders’ efforts to increase deficit spending to pay for increased defense expenditures. We’ll also get US CPI data, although I dare say inflation has become a secondary concern at this point given the growth scare going on in the US.

Stay calm, stay diversified, and keep your investment time horizon in mind as you follow headlines that can be unnerving and stomach-churning.

Dates to watch