By Yoruk Bahceli and Samuel Indyk
LONDON, Dec 18 (Reuters) – For European markets overshadowed by the United States since the summer, investors are hoping a spending bonanza in Germany – the European Union’s biggest economy – moves the dial in 2026. But first, they need to see evidence it will deliver.
A Ukraine peace deal could boost sentiment too. European stocks have barely recovered the cash that has left since Russia’s 2022 invasion of its neighbour.
European shares outperformed U.S. stocks in the first half of 2025. The region united to boost defence spending, Germany shook up its borrowing rules, and U.S. President Donald Trump’s tariffs dented investor confidence in American assets, generating a long-awaited MEGA, or “Make Europe Great Again” moment.
But as tariff fears have abated, European stocks, though continuing to rise, returned to their usual pattern of underperforming U.S. shares, while the euro remains below September’s four-year high near $1.20.
European equities have seen just over $86 billion of inflows in 2025, but the pace has slowed to $23 billion in the last six months, according to EPFR data tracked by Barclays.
They are projected to do well again next year but are nonetheless likely to remain in the United States’ shadow. Four of the six biggest U.S. and European investment banks expect Europe to lag, also due to U.S. markets’ greater exposure to the AI boom.
For the euro, much will hinge on how the U.S. dollar fares. Highlighting the uncertainty, two of the banks expect the European currency to drop.
“Now the focus turns on what Europe can do in terms of a ‘pull’ factor given the ‘push’ factor out of the U.S. isn’t going to be as pronounced as we thought,” said Arun Sai, Pictet Asset Management senior multi-asset strategist.
GERMAN DELIVERY KEY TO BOOSTING STOCK PERFORMANCE
In March, Germany, which accounts for roughly a quarter of the 28-nation bloc’s gross domestic product, overhauled its fiscal rules to boost infrastructure and defence spending, a potential game-changer for Europe’s economy.
But it has been using some of that leeway on day-to-day spending rather than the kinds of additional infrastructure that would boost the economy and stock performance more durably.
Infrastructure spending will pick up in 2026, but Barclays economists say that, looking across this year and next, social spending is rising faster.
Germany’s budgetary plans are “not as ambitious as we would have liked,” said Ross Hutchison, head of euro zone market strategy at Zurich Insurance Group, which favours U.S. stocks over European.
Hutchison said high overall spending was still positive, but he would like to see more go to infrastructure with greater long-term impact.
Execution risk is also high, given Germany has underdelivered on investments in recent years, analysts say. Last week, three German economic institutes downgraded their 2026 growth forecasts, citing limited momentum from spending and slow progress on structural reforms.
Market valuations reflect pessimism too. German stocks are up 20% this year but have not gained in the second half. European stocks are trading at a roughly 35% discount to their U.S. rivals relative to forward earnings, near record lows.
That means there is plenty of scope for inflows if Germany delivers and sentiment improves, investors said.
“The bar is very low,” said Schroders fund manager Dominique Braeuninger, who is starting to favour European stocks in his funds.
A pickup in earnings for STOXX 600 companies next year following a 2025 contraction could add momentum too, based on LSEG I/B/E/S estimates.
As for Ukraine, peace or even a ceasefire would help boost sentiment. Assets under management at European equity funds are down 14% since the start of the war, and recent inflows have only brought back a tenth of the money that left, according to Citi.
But the initial impact would be more sector-specific and come from lower energy prices, analysts said.
Investors will also watch whether European firms can benefit from the reconstruction of Ukraine, which could cost more than $500 billion over the next decade.
EURO REMAINS DOLLAR DEPENDENT
The euro, meanwhile, is up 13% on the dollar in 2025, its biggest annual gain since 2017. But it has plateaued since June.
The impact of German stimulus, Ukraine peace efforts and European Central Bank policy will help drive the euro, but much will depend on the dollar and whether concerns around its safety resurface, investors said.
Goldman Sachs, whose $1.25 forecast tops a Reuters poll, expects that euro gain to largely stem from dollar weakness, as a slowing U.S. economy prompts more Fed cuts.
But UBS, seeing little reason for a dollar sell-off, forecasts a drop to $1.14.
“Most of the time FX is more dominated by what happens in the U.S. and what the Fed does, and I think we are still there,” said Andreas Koenig, head of global FX at Europe’s largest asset manager Amundi.
(Reporting by Yoruk Bahceli and Samuel Indyk; Additional reporting by Dhara Ranasinghe and Alun John; Editing by Amanda Cooper and Joe Bavier)
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