Gateway to Europe

One of the most notable highlights of equity markets so far this year has been one of the best performances of the Dax relative to the S&P500 since the 1960s.^[7] As of August 25, the Dax has gained over 20% in euro terms (around 37% in dollar terms), while the S&P 500 is up around 10% measured in dollar year-to-date, as Figure 3 is showing. However, the latter translates into a slight loss when translated in euro, as a result of the weak dollar. This European outperformance versus the U.S. has come to a halt in the second quarter for three main reasons we believe:

1. The ongoing AI strength and less damage from the U.S. tariff announcements have helped U.S. equities rebound after a very weak first quarter.
2. Currency headwinds for European companies.
3. Central bank policy expectations have changed. We expect the U.S. Federal Reserve (Fed) to have significantly more leeway to cut rates than Europe leading to five cuts (each 25 basis points, bps) for the former and just one cut for the latter in the coming four quarters.

These differing policy paths, however, come at a price, as they indicate differing growth paths, as we have talked about earlier, with U.S. rates staying well below past years’ levels and European growth even performing above potential for some years. And while we have certainly seen a certain fatigue in European markets as the European transformation story has been priced very aggressively in the first quarter, we don’t believe that stock markets have fully appreciated what is to be expected in the mid-term: Expansionary fiscal programs concentrating on the energy transition, digital infrastructure and defense; accelerating earnings growth, also fueled by the potential for lower energy prices and finally there is the valuation gap and the need to diversify away from a very U.S. and tech-centric equity markets: the U.S. currently account for almost 70% of the developed market capitalization (against an 20-year average of 57%), whereas the ten biggest companies of the S&P 500 account for almost 40% of the index market cap – a historic high. All this, as we show later, has led to European equities trading at a near-record valuation discount to their U.S. peers.

Figure 3: The Dax still leads year-to-date, but the S&P 500 has regained strength versus Europe in the second quarter

^{Sources: Bloomberg Finance LP, DWS Investment GmbH as of 8/25/25}

European earnings (as measured by the combined earnings before interest and taxes (EBIT) of the Stoxx Europe 600) have been basically flat in the decade from 2010 and 2020. They have, however, increased by almost a quarter since the beginning of this decade. We expect the earnings dynamic to persist for some more time. To name but a few potential drivers: reaccelerating economic growth in Europe and Europe’s trading partners; tailwind from Europe’s fiscal programs and plans to axe red tape; benefiting from the urge to form stronger global trading alliances without the U.S., and potentially lower energy prices if the war in Ukraine settles. From a shorter-term perspective, however, European companies had to incur some headwinds, such as a strengthening euro, burdens and uncertainties stemming from U.S. tariff frictions as well as disappointing German growth in the first half of 2025. As Figure 4a shows, this has led to a more positive reception of 2Q25 reporting season in the U.S. compared to Europe. However, we would highlight the fact that earnings expectations for 2026 for Europe remain strong, as Figure 4b is showing, with expected year-on-year growth in Europe coming close to expected growth in the U.S.  

And while this is certainly an open question, we would also like to suggest that AI has the potential to surprise on the positive side for European, and on the negative side for U.S. equities next year. How is that? U.S. equity performance and valuations over the past three years have been strongly pushed by AI pioneers. We are now turning to the next phase where deployment of AI tools is expected to become more important: which companies are best positioned to use AI in order to grow sales or cut costs? We expect they should be spread more equally amongst European and U.S. companies, whereas valuations of AI pioneers might come under pressure as a result of overcapacity in this space.

Figure 4: The reporting season for the second quarter has benefitted U.S. equities. For 2026, however, year-on-year earning growth is expected to converge

^{Sources: LSEG Datastream, DWS Investment GmbH as of 8/22/25}

And then there is valuation. As Fig. 5 is showing, the valuation discount of European equities relative to the U.S. is close to 40%. From 2005-2020 the discount has averaged 16%. Valuation metrics are seldom a good timing indicator, as the chart also shows: European equities have underperformed their U.S. peers for the past 20 years, with only small interim periods of reversal. But at 40%, the valuation discount certainly seems to be over-confident for U.S.- and over-pessimistic for European equities. Not least, as we should also not forget to mention, as the U.S. is embarking into unchartered territories when looking at the combination of a high debt/GDP ratio, an extreme high twin deficit (budget and trade) and, to put it mildly, unorthodox domestic and foreign (trade) policies by the current U.S. government. We would not be surprised, if as a result of the latter, foreign direct capital inflows would flow into the U.S. at a slower speed or even reverse course (again, Fig. 5).

From a sector perspective, we see various routes to potentially capture this more constructive market outlook. European fiscal expansion is largely focused on industry with underutilized sectors likely to benefit the most. In addition, financials, communication services and utilities may be supported by favorable earnings as well as being resilient to the effects of a weaker U.S. dollar and tariffs. We would also favor small- and midcap companies, which may have the potential to outperform in cyclical upswings, but they are also trading at a steep discount to large caps. In addition, with European small- and midcaps more domestically orientated, this may offer potential risk management against negative tariff surprises from the U.S.

Alongside U.S. Treasuries, the European bond market — particularly German government bonds — has long been regarded as a potential safe haven^[8] in turbulent times. Thanks to currently attractive yields, a steeper yield curve, and the prospect of a further interest rate cut by the ECB, we believe that German government bonds are currently particularly appealing, especially compared with U.S. government bonds. Although the relaxation of budget rules in Germany led to a sharp, temporary rise in Bund yields at the beginning of the year, the higher debt burden in the U.S., and the potentially greater negative impact of U.S. tariff policy on growth and inflation in comparison with Europe, could ultimately favour continued diversification away from U.S. government bonds and towards German government bonds.

There are essentially four factors that underscore the current attractiveness of German government bonds:

Capital is flowing from the U.S. to Europe, particularly to Germany

Concerns about excessive fiscal policy in the U.S. might be leading to some rebalance from the U.S. to Europe,^[9] with German government bonds likely to be a beneficiary. The volume of outstanding U.S. government bonds is much greater than the volumes outstanding in the Eurozone, or specifically in Bunds. Against this backdrop, it is clear that only a relatively small proportion of Treasuries would need to be sold or shifted to have a noticeable impact on the Bund market. With issuance volumes likely to rise in the coming years due to investment plans in Germany, the Bund market should be well equipped to absorb longer-term capital flows from the U.S.

Familiar investment strategies are expected to take effect again

Since September 2024, the yield curve for German government bonds in the two- to ten-year range has not been inverted for the first time in 22 months – in other words, higher yields are once again being paid on longer maturities. One investment strategy resulting from an upward-sloping yield curve is known as “rolling down the curve.” This strategy involves buying longer-term bonds, which, in this scenario, offer higher yields. Investors benefit from the fact that the yield on the bonds falls (and their price rises) as they approach their maturity date. When rolling down the yield curve, investors sell the securities before their final maturity. This strategy can potentially provide investors with additional income without significantly increasing interest rate risk, since price volatility decreases as the bond approaches its maturity date.

Compared to history, current yields appear attractive

From a shorter historical perspective, the ranges in which the market has been moving since around September 2022 are interesting in view of the yields on offer. Since the beginning of 1990,^[10] the average yield on ten-year maturities has been around 3.50 percent. However, since the beginning of 2012, yields on this maturity have remained below the two percent threshold. Against this backdrop, the current yields on offer appear in a very positive light indeed.

The tense geopolitical situation is likely to continue supporting safe haven^[8] flows

If there are doubts about the solidity of U.S. Treasuries, the world's largest bond market, German government bonds quickly come into focus. The financial solidity of German government bonds is generally regarded as “beyond doubt.”^[11] Although this view was seriously tested by the investment programmes adopted in Germany for the next twelve years, the prevailing view is that Germany will not overextend itself. Furthermore, we are not alone in assuming that the German government bond segment will be able to cope with the necessary new borrowing. Spreading this over a period of twelve years should keep the burden on the federal government within reasonable limits.

German government bonds currently appear more attractive than they have in recent years. Political decisions and measures have led to U.S. Treasuries being viewed more critically, resulting in above-average performance for Bunds in the two-and-a-half months following Liberation Day in April 2025. We believe this trend is likely to continue for some time. Safe-haven^[12] flows from the U.S. into European government bonds are probably overestimated. Nevertheless, investors seem increasingly convinced that diversifying away from U.S. Treasuries and into German government bonds could be an attractive portfolio strategy.

German government bonds may benefit from their solidity, a steeper yield curve compared to U.S. Treasuries, and an attractive yield compared to recent years. ^[12] While we do not anticipate significant yield declines, particularly in longer maturities, the factors outlined in this publication provide compelling arguments in favour of German government bonds. Looking ahead, the risk/reward ratio for German government bonds appears balanced, with their attractiveness stemming from the status quo — particularly when compared directly with U.S. Treasuries.

Foreign exchange tailwinds: currencies matter

Looking at the dollar, it seems obvious that a certain skepticism toward the dollar is at least an issue that is increasingly preoccupying the markets. Although the dollar has traditionally been a reliable diversifier during periods of market volatility, the current market phase appears to be different, with the U.S. itself becoming a source of turbulence in the financial markets. This is reflected in the U.S. dollar index's worst performance since the introduction of flexible exchange rates in 1973: it depreciated by just over 10%^[10] in the first half of 2025 and suffered additional losses against the euro. The situation is further complicated by the historically stable correlation between the U.S. dollar and U.S. government bond yields, which has largely broken down since Liberation Day in April. In our view, this reflects concerns about U.S. trade policy, high credit demand and the independence of the U.S. Federal Reserve. These structural issues present a significant challenge for international portfolios.

Despite the weakness of the dollar, the German fiscal package for defense and infrastructure might prop up the growth outlook and pull up Eurozone growth also, political uncertainty in the U.S. could prove favorable for an investment shift to the Eurozone and push the Euro. We expect the strength of the EURUSD levels to stay amid increased uncertainty and investors diversifying. This could encourage for example European-based investors to focus more on local currency investments.

Portfolio rotation: global investors reallocating from U.S. to Europe

The increased focus on European capital markets has been prominent for a while now. For several months now, global investors have been reallocating their funds from U.S. equities and fixed-income securities to European assets. Data on inflows into European exchange-traded funds (ETFs) confirms this picture. According to the latest Morningstar data,^[13] investors have continued displaying caution to both U.S. equity and bond markets. U.S. large-blend equity ETFs saw outflows of ca. EUR 3 billion in the second quarter 2025, while European and Eurozone equity ETFs have attracted almost EUR 8 billion inflows in the same period. Overall, investors do not demonstrate a complete aversion to the U.S., but we do see attempts at more regional diversification where European markets are clearly capitalizing on this. Finally, within the DWS long-term capital markets assumptions framework (DWS Long View), our return expectations on a ten-year forward-looking basis for European equities remain attractive compared to their U.S. counterparts. In local currency terms, we expect an annualized return of 6.2% for Europe and 5.9% for the S&P 500 index.

In the context of a plethora of uncertainties about the current U.S. trade policies and debt sustainability, coupled with occasionally strong currency movements, a typical European investor might be forgiven for attempting to re-evaluate the place of USD-denominated bonds in her portfolio. Some investors also already act on it: Euro government and corporate bond ETFs have been the top two flow categories in the European fixed income ETF space in the second quarter, attracting around EUR 4.5 billion in total. From a risk allocation perspective, a shift into EUR-denominated bonds at the expense of U.S. ones could seem sensible. The active risk from such a move would likely increase by a third compared to an equivalent shift from U.S. to European equities. Moreover, for those European investors holding U.S. Treasuries on a currency-hedged basis, the spread between both 10- and 30-year currency-hedged U.S. government bonds and German government bonds has been negative since February 2025.

European real estate is undergoing a notable resurgence, drawing increasing interest from global investors. The region’s property market is emerging as a strategic “pinch hitter”—a term borrowed from baseball to describe a substitute player brought in at a critical moment. In this context, Europe appears to be stepping up underpinned by improving liquidity, supportive fiscal policy, and persistent supply constraints.

Urban resilience is a defining feature of this recovery. Gateway cities such as Berlin, Amsterdam, and Paris are outperforming national averages, driven by strong occupier fundamentals and demographic vitality. These cities are projected to see an 8% increase in their working-age populations over the next decade, while the broader European landscape faces a 3% decline.^[14] This urban dynamism is attracting talent, businesses, and capital, reinforcing the appeal of real estate investments in these locations. The resilience of these cities is further evidenced by robust rental growth, low vacancy rates, and a healthy demand for high-quality space.

Fundamentals across the European real estate market are strong. The region is currently benefitting from historically low supply levels, land scarcity, and stringent planning regulations, which is contributing to structurally low vacancy rates, approximately half the level of the U.S.^[15] We expect this supply-side tightness to intensify, and we project a 25–30% drop in new supply over the next five years. Development margins have compressed due to rising construction costs and falling exit values, creating an increasingly challenging environment for new developments. These constraints are expected to exert upward pressure on rents, particularly in already constrained markets, and provide the groundwork for secure cashflows.

Europe may not just weather global challenges

The living sector stands out as a particularly attractive segment. Chronic undersupply, stable income, and structural demand drivers such as urbanization, ageing populations, and student mobility are creating a potentially robust investment environment. Vacancy rates in key cities are in the 2–3% range, with rent growth over the next five years forecasts of 4-5% per annum in places like Copenhagen, Berlin, and Madrid.

Given the fundamentals and supply outlook, value-add strategies in the living sector may offer compelling opportunities. These include refurbishing outdated assets, repurposing underutilized spaces such as offices and car parks into residential units, and developing future-fit living solutions aligned with environmental, social and governance (ESG) standards. High-density cities with land scarcity, ageing property stock, and regulatory incentives for modernization may offer favorable conditions for such strategies. Access to subsidized loans and ESG-certified financing could further enhance the viability of these investments.

In this period of global uncertainty, European real estate may offer relative stability, predictability, and potentially compelling risk-adjusted returns. The combination of resilient cities, constrained supply, and sector-specific opportunities may support the region’s appeal as a strategic investment destination. With values at cyclical lows and liquidity on the rise, Europe may not just weather global challenges — it has the potential to thrive amid them. The investment renaissance underway is not merely a cyclical rebound but a structural reawakening, driven by fundamentals, fiscal support, and a renewed investor focus.

Infrastructure will also be at the heart of Europe’s renewal, with the clean energy and digital infrastructure sectors being some of the key beneficiaries of both fiscal expansionism and an uptick in private sector interest. As it stands, the European infrastructure market is the largest and most developed globally, with transaction opportunities spanning across every sector.^[16] Underpinned by stable and long-term regulation, the market has long attracted international capital looking to benefit from defensive, uncorrelated returns in their portfolios. However, the combination of the growth of large, globally focused infrastructure funds in recent years, and of the U.S. infrastructure market’s attractiveness on the back of the Inflation Reduction Act, has seen Europe cede market share to North America. Compounding this, while European infrastructure may be structurally attractive, the economies that it serves have been lagging from a growth perspective relative to more dynamic markets like the U.S. and those in Asia.

More competitive growth levels and a streamlining of bureaucracy should work to boost the attractiveness of European assets, but it is the focused fiscal support for the infrastructure market that is driving an uptick in investor attention on Europe. Higher levels of fiscal spending in the region will broadly be supportive for infrastructure assets due to higher levels of economic activity, but it is the EUR 500 billion German infrastructure package which has the potential to create significant opportunity for investors. This package, approved by both the German Bundestag and Bundesrat, will be deployed over 12 years. It will support a wide range of infrastructure initiatives, from traditional transport and municipal upgrades to energy efficiency, electric vehicle (EV) charging, and hydrogen infrastructure.

This public capital is not expected to crowd out private investment. Instead, it is designed to target large-cap, core infrastructure networks like rail and grids, while at the same time leverage in further private capital into the infrastructure markets where it has a greater presence, such as more commercial sectors like digital infrastructure, renewables, and energy efficiency. More information about the deployment of the infrastructure spend is expected over 2025, but it represents an attitudinal shift in approach to infrastructure investment in Europe and joins other major markets such as France and the U.K. in publicly committing capital to infrastructure.

The digital infrastructure market is central to Europe’s plans to become globally competitive and – crucially – more independent. Europe needs more data centers because demand is structurally outpacing today’s supply; AI and cloud are lifting compute intensity and energy needs faster than efficiency gains can offset. To lessen the dependence on U.S. tech firms and their data center capacity, as well as to give European tech firms the tools with which to develop Europe’s AI capabilities, the EU as well as national governments across Europe are looking to support the development of data center capacity through various initiatives. The AI Continent Action plan, announced in April 2025, aims to position Europe as a global leader. Within this, InvestAI will support EUR 200 billion of investment, including the development of several gigafactory scale data centers with EUR 20 billion, as well as encourage AI adoption across industry.^[17] There are also several national-level initiatives, such as those in France^[18] and the U.K.^[19]

Energy security remains the chief concern of European policymakers, but as a region still heavily reliant on international imports in the form of natural gas, this also means that the low-carbon energy transition is of equal importance. Europe’s only largescale energy source available domestically, at scale, is renewable energy and thus wind and solar remains paramount and a crucial opportunity set for infrastructure investors. Europe has long led the way in rolling out renewable energy, but the 2022 energy crisis and REPowerEU policy that was introduced to remove Russian gas from the energy mix has accelerated market growth. Combining with the need for better grid integration and clean energy manufacturing in the region, the Clean Industrial Deal is the latest policy step which aims to gather momentum in the clean energy market and looks to deploy over EUR 100 billion in public and private investment..^[20] While the U.S. – which has recently been attractive to infrastructure investors in the clean energy space due to attractive tax credits – has been experiencing significant policy uncertainty in recent months in the clean energy space, Europe has been continuing to evolve its support to ensure that the complexities of the energy transition are matched with adequate policy support.

The European market is currently facing a unique set of economic and geopolitical challenges, including increased fiscal spending needs, regulatory changes, and the need for enhanced defense capabilities. Private credit steps in to fill the gaps left by traditional banking systems, which are constrained by higher capital requirements and regulatory pressures. 

One of the primary ways private credit helps the European economy is by providing alternative financing solutions to small- and medium-sized enterprises (SMEs). With the new Basel III regulations increasingly imposing additional capital requirements on bank lending, there is a growing need to combine bank lending with private and public capital markets to finance expansion. Private credit firms offer bespoke, highly structured financing solutions that are not viable for bank balance sheets due to regulatory charges. This allows SMEs to access the necessary funds to grow and innovate, thereby strengthening the overall economy. 

The European private credit market, particularly in the lower mid-market segment, has shown potential for more favorable risk-adjusted returns compared to the upper mid-market due to lower leverage levels, strong documentation protection, and potentially better margins. Additionally, asset-backed financing (ABF) within the private credit market is expected to experience higher growth than direct lending, offering potential alpha diversification for investors. ABF strategies are secured against granular pools of assets, providing potential for diversification benefits and downside risk management.

Furthermore, the evolving partnerships between banks and private credit firms enhance the investment landscape. These partnerships leverage complementary capabilities, allowing both parties to potentially achieve better outcomes for their clients. For instance, banks can retain their client relationships and lend to areas constrained by risk-capital requirements, while private credit firms benefit from banks' extensive origination networks. This collaboration not only supports the financing needs of various sectors but also helps mitigate systemic risks by reallocating risk from leveraged bank balance sheets to the portfolios of long-term sophisticated investors. 

Europe has a clear mission in terms of decarbonization, the deployment of renewables and diversification away from Russian gas. Since 1990, European greenhouse gas emissions have declined by 37% despite a 68% increase in the region’s GDP over the same period.^[21] This success has been achieved in part by the rapid deployment of renewables which now account for over 45% of total power generation. This trend will continue. According to the IEA,^[22] Europe is committed to continue to invest in renewable energy, spending over USD 400 billion each year between 2026 and 2030. This has also facilitated Europe’s efforts to reduce its heavy reliance on Russian gas under the REPowerEU initiative. Alongside increased liquid natural gas (LNG) exports, most notably from the U.S., this has led to the share of European natural gas imports from Russia falling to just over 10% in the second quarter of this year compared to nearly 50% prior to the Russia-Ukraine war.^[23]

Europe’s energy ambition requires further grid investment which will connect sources of new renewable energy generation sites to the European grid. Additional demands on the grid will also be triggered by the power requirements of data centers to support growing power demand from the AI and Generative AI sectors. According to International Data Corporation (IDC), the top five European sectors with the largest spending for AI and Generative AI industry will total USD 31 billion in 2025, with an expected compound annual growth rate between 2024 to 2028 close to 30% per annum.^[24] Increased data center investment will support copper and aluminium demand as data centers are among one of the most electricity intensive industries.

Additionally, the Readiness2030 initiative will mobilize EUR 800 billion in defence spending and will underpin the North Atlantic Treaty Organization (NATO) commitment to raise defence and security spending to 5% of GDP by 2035. ^[25] This spending will be heavily tilted towards building out industrial and manufacturing capacity, driving up demand not just for steel, but all other industrial metals such as zinc, aluminium, and nickel that form part of the manufacturing process.