European stock markets have demonstrated robust growth in recent years, but performance has been far from uniform. While the Morningstar Europe Index has risen by 9.8% in euro terms since the beginning of 2025, following gains of 8.7% in 2024 and 15.5% in 2023, significant disparities exist between national markets, and valuations are increasingly diverging.
Uneven Performance Across Europe
The gains haven’t been shared equally. Germany’s Morningstar Index has seen a rise of 19.3%, while France and the UK have experienced more modest increases of around 8% each. However, the most striking differences are at the extremes. Spain and Italy have emerged as the top performers, achieving returns of 26.0% and 20.7% respectively. In stark contrast, Denmark has lagged significantly, with a 12.4% decline.
This divergence in performance is also reflected in market valuations. As of May 28th, the Morningstar Europe Index traded at a price/fair value ratio of 0.98. This indicates that, the European market is undervalued by approximately 2%. However, a closer look at individual countries reveals a more complex picture.
Italy and Spain: Overvalued Amidst Sector Strength
Italy and Spain currently stand out as the most overvalued markets in Europe. This is largely attributed to the strong performance of their financial sectors, which comprise 45.4% and 38.1% of the market capitalization in Italy and Spain, respectively. The European financial sector has been a leading driver of gains in the first five months of 2025, increasing by 23.1%.
The concentration of gains within the financial sector in these two countries appears to be driving up valuations beyond what might be justified by broader economic fundamentals. This concentration raises questions about the sustainability of the current valuations, particularly if broader economic growth remains sluggish.
Broader Economic Context and Earnings Expectations
The performance of European markets is unfolding against a backdrop of subdued economic growth. , reports indicated that European corporates are expected to deliver their worst earnings growth in the past seven quarters. This anticipated slowdown in earnings growth adds a layer of complexity to the current market valuations.
A stronger euro against the dollar, as of , is also expected to weigh on European earnings. Bank of America (BofA) estimates the impact of a stronger euro will be felt across the region, potentially dampening overall profitability.
Fund Flows Reflect Market Sentiment
Investor sentiment appears to be aligning with the performance trends. The highest-performing stocks have attracted significant fund inflows, totaling $1.67 billion this month. Of this, $0.25 billion came from active funds and a substantial $1.42 billion from passive funds, suggesting broad-based investor interest in the leading markets. Conversely, the lowest-performing group has only drawn $0.39 billion in inflows.
This flow data suggests that investors are actively seeking exposure to the markets and stocks that have already demonstrated strong performance, potentially exacerbating the existing valuation discrepancies. The preference for passive investment vehicles further reinforces this trend, as funds tracking broad market indexes automatically allocate capital to the best-performing constituents.
Implications for Investors
The current environment presents both opportunities and challenges for investors. While the overall European market appears modestly undervalued, the significant variations between countries and sectors require a discerning approach. Investors should carefully consider the valuation of individual markets and the potential impact of macroeconomic factors, such as currency fluctuations and earnings growth, on future returns.
The overvaluation of Italy and Spain, driven by the financial sector, warrants particular attention. While these markets have delivered strong returns recently, investors should assess whether the current valuations are sustainable in light of the broader economic outlook. A more cautious approach may be warranted, particularly for those seeking long-term value.
The divergence in performance also highlights the importance of diversification. Investors should avoid concentrating their portfolios in a single market or sector and instead consider a broader allocation across European countries and industries. This can help mitigate risk and capture opportunities across the region.
Looking ahead, the trajectory of European stock markets will likely depend on a combination of factors, including economic growth, corporate earnings, and monetary policy. The anticipated slowdown in earnings growth and the potential impact of a stronger euro pose headwinds, but the overall market remains underpinned by relatively attractive valuations and continued investor interest.
