European equities have been underperforming their American counterparts almost continuously since 2008. Recent years have seen the artificial-intelligence boom benefit American and Chinese technology giants, while the war in Ukraine has significantly increased Europe’s energy costs. The pivot toward electric cars has left the powerhouse German auto industry lagging behind Tesla and China’s BYD.

To add to these challenges, the new U.S. administration has threatened to place tariffs on European goods and cut European Union leaders off from peace negotiations with Russia. In a speech in Munich, Vice President JD Vance lambasted the bloc and urged its member countries to rely on their own military spending. He stated, “The EU needs to stand on its own feet and invest in its own defense capabilities.”

Despite these hurdles, the Euro Stoxx 50 has surged 12% since the U.S. election, compared with 3.5% for the S&P 500. Europe-focused equity funds recorded their biggest inflow since early 2022 during the third week of February, according to analytics firm EPFR.

Part of the explanation for this rally lies in Europe being an obvious place to diversify into bargain “value” stocks now that the “Magnificent Seven” technology giants’ sky-high valuations have started to look frothy. Based on the earnings yield forecast for the next 12 months, European equities offer a 6% premium over inflation-protected government bonds. This is twice as much as U.S. stocks.

Additionally, the latest purchasing managers’ indexes, while lackluster, suggest that Germany’s manufacturing recession could soon end, at least absent a new shock from tariffs. Wall Street analysts expect carmakers Volkswagen, BMW, and Chrysler owner Stellantis to start reporting positive growth in earnings-per-share—the metric that is historically best correlated to their share prices—in the second half of the year.

What is special about this European rally, however, is that it doesn’t just appear to reflect a bounce from the bottom, but a more durable transformation. This is what Mizuho strategist Jordan Rochester has dubbed the MEGA, or “Make Europe Great Again,” trade.

Last year, former European Central Bank President Mario Draghi unveiled a report in which he urged policymakers to cut the huge amounts of red tape that clog the bloc’s internal market. He is now being joined by an increasing number of voices. Last week, for instance, central banks in Germany, France, Italy, and Spain wrote a letter asking the EU’s executive arm to water down new bank capital rules that took effect in January.

A crucial area of reform that the EU is looking at is allowing its banks to park more of their assets outside of their balance sheets: Relative to economic output, European issuance of securitizations is 1/13 the size of that in the U.S. Recent roadblocks to cross-border mergers, such as UniCredit’s attempted purchase of Commerzbank, are within officials’ power to solve.

Once-belaguered eurozone lenders such as UniCredit and Banco de Sabadell have revalued to trade above tangible book value, when they were significantly below it a year ago. Despite a recent rally, big investment banks such as Deutsche Bank and BNP Paribas retain larger discounts and could have further to go, especially if there are meaningful banking reforms.

Draghi has also argued for promoting key sectors such as electric vehicles and chips. A few days ago, Brussels approved 920 million euros, equivalent to about $960 million, of German state-aid to help the country’s largest chip manufacturer Infineon build a new semiconductor plant.

While such investments need to be of a much larger order of magnitude, EU fiscal rules stand as a big impediment. Just the cost of eurozone NATO nations increasing their defense spending to 3% of gross domestic product would be about 1% of the bloc’s output, Capital Economics estimates. To make room for this, European policymakers may have to create escape clauses in the rules that bind individual countries, or else allow for extra borrowing at the EU level.

As precedents such as the post-World War II period and the Ronald Reagan era show, though, it isn’t rare for economic turnarounds to start with military procurement sprees, and the urge to offset a U.S. pullback could set a useful precedent for Europe spending elsewhere.

Indeed, the defense push is already forcing officials to design an industrial strategy, because European military contractors only supplied 22% of the bloc’s defense needs between mid-2022 and mid-2023, compared with a target of 50% for 2030. Germany’s €100 billion special fund launched after Russia’s invasion of Ukraine, for example, mostly served to buy Lockheed Martin’s F-35 fighters.

In the short term, extra spending will focus on immediate needs such as ammunition and missiles. But the EU will also need to slowly align different governments’ development and procurement plans for aircraft, ships, and tanks, and promote consolidation and collaboration between firms. This is auspicious for the shares of companies such as Leonardo, Thales, Safran, and Rheinmetall, which are powering ahead so far in 2025.

The crucial question for markets is whether Germany—the nation that has so far hampered fiscal spending domestically and across the Continent, as well as EU strategic autonomy—will also change course. On Monday, on the day after winning the general election, center-right leader and longlife Atlanticist Friedrich Merz publicly argued for security independence from the U.S.

The euro crisis and the aftermath of the pandemic already showed that Europe is capable of reacting when it must pull itself back from the brink. What investors should keep in mind is that it always seems to keep teetering on the edge of it afterward.

In conclusion, while Europe faces significant challenges, the recent resurgence in its equities market suggests a potential for a more durable transformation. The MEGA trade, as dubbed by Jordan Rochester, could signal a turning point for European markets, driven by reforms and strategic investments. However, the path forward will require overcoming significant fiscal and regulatory hurdles, as well as a shift in Germany’s stance on defense spending and strategic autonomy.