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I wrote our quarterly client overview yesterday. This is a deeper dive into our views and positioning and, as ever, if you are not a client and want a copy then please do get in touch. One point I made there was that diversification has made a comeback in 2025. After what felt like a lifetime of US equities being the only decision you really need to make, this year you have had to think a bit harder. Europe outperformed in Q1 on the back of a boost to infrastructure and defence spending. But the AI boom helped the US outperform in Q2 and it was long-time disappointer, Emerging Markets that came top in Q3, driven by a resurgent China. Having meaningful allocations to each of these regions has helped in 2025. That was just not the case for much of the last decade.
I should mention here that the performance above is in local currency terms. But it is worth saying it also holds up in unhedged local currency terms. For example, here are quarterly returns in Euro terms (which our Euro denominated clients will appreciate as the Euro is much stronger this year):
So even allowing for currency movements, European equities have lagged other major markets since the end of March (and the same is true for the UK). I was therefore surprised to see that flows into European equities have remained strong recently (flows often follow returns, not the other way round):
What is going on here? It is tempting to say that after the one-off positive surprises in Q1 (especially for the European defence sector), Europe has drifted back to its normal lacklustre performance. And a slowdown in luxury goods and a bear market in healthcare has hurt some of its previous highflyers such as LVMH and Novo Nordisk. But I also think there are a couple of attractions to Europe here. The first comes from fact that there is more to the diversification benefits than just headline performance. You also have some diversification in investment themes and styles. In the US, growth has outperformed value once again led by all things AI and technology. However, and at the same time, value stocks in sectors like banks and defence have been leading the way in Europe. Having value and growth both working means you are less all-in on one particular theme. You might not notice this in a bull market, but it should help if and when one of these themes start to rollover and disappoint.
The second point to make is that even after the Q1 rally Europe remains cheap even after you allow for the fact that it is growing more slowly. Investors are right to pay more for markets with better growth, and a large part of the US valuation premium reflects this. However, Europe still looks cheap after adjusting for this growth differential. One way to measure this is to look at the PEG ratio, which is ratio of the price you pay to the growth you expect to get. As you would expect, the US and Europe tracked each other pretty closely for much of the last twenty years. However, they decoupled pretty sharply around the end of 2022:
Of course, the end of 2022 coincides neatly with the start of the current AI boom. One way of interpreting the chart above is that the market thinks that gains accruing to AI will be (i) larger than people expect today and (ii) will accrue mostly to US companies. This may, of course, prove to be right. But there are plenty of reasons to at least consider (i) this might be an AI bubble or (ii) the gains from AI might accrue to existing (or new) businesses rather than the AI providers. And, if this is your concern, then European equities with their lower valuations and focus on the old world of defence and financials may yet provide some good diversification. Using this lens, those continued flows into European equities make some sense to me.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
