Venu Krishna: Hello, and welcome to The Flip Side. I'm Venu Krishna, Head of US equity strategy at Barclays, joined today by Manuel Cau, Head of European Equity Strategy. Our debate today centers around a simple question ‘Will European equities finally beat their US counterparts in 2025?’

Emmanuel Cau: I've been looking forward to this discussion. It's a simple question to ask, but perhaps a bit more difficult to answer, and probably on many investors' minds. Thanks to this year's unexpected start, we are performing the most among the main regional equity markets so far.

Venu Krishna: Emmanuel, I feel like I've seen this movie before.

Emmanuel Cau: Yes, it's true, but the idea that this year will finally be Europe's time to shine is a perennial contrarian trade that has rarely worked. But I think 2025 could be it.

Venu Krishna: Right? So to determine whether this really is Europe's moment, we're going to consider the macro backdrop on both sides of the pond. The geopolitical outlook in Europe, Trumponomics, the influence of Big Tech, currency and rate effects and why the persistent discount on European stocks versus US stocks exists?

Emmanuel Cau: Okay, let's get into it.

Venu Krishna: So to start with, the S&P 500 has outperformed the STOXX 600 more than two thirds of the time over the last 25 years since 2016. Europe only beat the US once and that was the bear market in 2022. So forgive me for being skeptical that this time will be different.

Emmanuel Cau: I think we should address the elephant in the room. The area you just mentioned lines up quite well with the rise of US tech dominance.

Venu Krishna: Yes, for most of the last decade, global investors chased upside in US tech stocks driven by the maturation of the mobile technology followed by cloud and now obviously AI. I believe tech will remain at the forefront of earnings in 2025, with a good chance of delivering upside against street estimates, even if growth decelerates a bit. Assuming I'm not completely off base. More than 40% of S&P 500 is in tech, media and telecom, compared to just 11% for Europe. That's quite a tide to swim against, don't you think?

Emmanuel Cau: Yes, I think it's hard to argue against big tech strength, but I think its dominance is a double-edged sword for US Exceptionalism. To your point, more than a third of US equity inflows since 2020 have gone to tech, and pretty much all the outperformance of US equities versus Europe is due to the Magnificent Seven. If you remove them from S&P 500, it has pretty much performed in line with Europe in recent years.

Venu Krishna: Well, you got me there. In fact, I think we saw more than $600 billion worth of Mag7 removed from S&P 500 in just one single day last week.

Emmanuel Cau: Exactly. The deepseek missile, as you call it in your report, is a wakeup call for overly concentrated and tech heavy global portfolios and reminded us that diversification has merits. I'm not bearish on tech, but if its performance normalizes going forward, it will make it easier for the European equity market to compete with or even beat the US, I think.

Venu Krishna: I don't think concentration is just a US problem though, Emmanuel. Having read your recent equity market review, it seems like half of Europe's January gains are from just three stocks, two of which are tech.

Emmanuel Cau: Ah, touche.

Venu Krishna: But let's take a step back. Even if you strip out the big six tech names, we still expect S&P earnings to grow 6% this year, higher than your forecast of 4% for Europe. Even though our estimate bakes in some downside from current consensus, the street also expects margins to expand about 70 basis points without big tech compared to Europe's just 15 basis points, and revisions are bifurcating. The forward earnings growth in the US is up 7% over the last 12 months, while in Europe it's down roughly 2%.

Emmanuel Cau: Whereas with Big Tech, it's hard to argue against stronger growth in the US. However, I know that year to date earnings revisions are starting to inflect higher in Europe, which is likely due to the benefit of a weaker Euro. You flagged in your recent report that earnings estimates outside tech have been sharply revised down for the US. In Europe, we are seeing early signs of bottoming out in activity with latest PMI stabilizing, and we think the ECB will cut rate to 1.5% by the end of the year, which is far more than the Fed. And that should help growth to pick up in the second half.

Venu Krishna: To be fair, Emmanuel, it seems to me like the stronger dollar and fed ECB rate differential are reflecting the more favorable macro setup in the US. The US economy, by the way, continues to be very resilient. And the virtuous cycle between income and consumption taking place within the strongest consumer base in the world is likely to fuel GDP growth superior to that of the Euro area, despite higher rates and a tighter labor supply outlook. In fact, our economists see US GDP growing 2.3% this year, while the euro area grows just 0.8%. This is a core component of my belief that US equities, which, by the way, are relatively insular, have a comparable advantage in terms of earnings momentum. Can Europe really overcome this, Emmanuel?

Emmanuel Cau: Well, I agree we need more positive catalysts, but I see several credible ones that could benefit Europe and somewhat improve its growth outlook. We expect a center right coalition to lead Germany after the election later this month, which would pave the way towards much needed supply side reforms and fiscal expansion. A stronger Germany is definitely key for a stronger Europe, as political fragmentation is the real trouble here, although I think the French government will manage to get the budget through, which would be a relief. A potential ceasefire in Ukraine would be a strong positive, and would be a key catalyst for global investors to re-engage with European equities reconstruction could help, but more importantly, the potential for further normalisation in energy supply and prices will be a positive for the region.

Venu Krishna: Well, we can't talk about fiscal policy without mentioning one of the most talked about developments on the world stage in the last few months, can we?

Emmanuel Cau: Yes. I think he was sworn into the White House just a few weeks ago.

Venu Krishna: Yeah. Trump has been a fixture in my conversations with investors over the last several months. From my perspective, I do think his trade and immigration policies could be a headwind for US growth. Not only are they potentially reflationary, but tariffs are likely to be a direct negative impact on S&P earnings growth without counting secondary effects. However, the president's priorities also include an extension of tax cuts and pro-growth deregulation, both of which could contribute to the US consumer strength and corporate earnings upside. I alluded to earlier, how does that fit into your view of US exceptionalism?

Emmanuel Cau: Well, so far at least, Trump's tariff threat has been less aggressive vis a vis Europe than many had feared. But Europe seems high on the list and its open economy is vulnerable to trade frictions. That said, I would not be surprised if concerns about a full-blown trade war also start to hit the US market and the perception of US exceptionalism at some point. Trump himself tweeted recently that there may be some pain which will make America great again.

The question is what is his pain threshold for markets and the economy? I believe that the aggressive Trump's deregulation agenda will also force Europe to follow. We are already hearing more voices in Europe asking for a shift in policy, and I think that Draghi's report could be back on the table. Europe has many global corporate champions, but we need more supportive policy.

Venu Krishna: Well, in fact, I was at the Barclays Global Macro and Inflation conference in January and heard Doctor Draghi's recommendation for addressing fragmentation in Europe. Fascinating stuff. However, another topic that came up at the conference was that even if China is the primary target of Trump's tariffs. Europe is likely to suffer due to its open economy.

Emmanuel Cau: While Trump is unpredictable, but I think he's transactional as well. And given tariff threat has inflated the risk premium for European equities. Less tariff could be a relief. I also believe that Trump may have less bargaining power than people think. He inherited a very strong economy, a very inflated equity market rates and dollar very high. So his margin for error is quite low.

Venu Krishna: So what I'm hearing from you, Emmanuel, is that perhaps there is too much bad news already priced in for Europe, whether it's Trump supply side reforms in Germany or the French budget. We only need a few of these catalysts to go the right way for European equities to keep outperforming. Is that correct?

Emmanuel Cau: Yes. And given how cheap and under owned Europe is, I think the bar for positive share prices is quite low and European equities could maintain their lead for the rest of the year. Europe outperformance in 2025 is definitely the pain trade.

Venu Krishna: It was certainly the pain trade in January, but to be honest, I think last month's rally was more like a catch up. Europe's underperformance against the US in 2024 was the biggest on record. What makes you think that further upside has durable, fundamental basis, rather than Europe being a short-term tactical trade?

Emmanuel Cau: At the end of the day, Europe is more a valuation than a call on growth, and I know that it has been the case for a while and never really worked. But given the potential catalysts I mentioned earlier, I think record valuation discount of Europe relative to the US and relative positioning because Europe is definitely under owned while the US looks quite crowded. Makes the asymmetry for Europe pretty positive.

Venu Krishna: Well, let's get into some of the nuances there. I think US equities were a crowded trade as recently as third quarter of last year, but the August sell off really washed out some of that extended positioning. More recently, we've seen long only funds come back and hedge fund exposure is far from stretched. Importantly, CTAs and risk parity funds have also trimmed their long equity exposures since September, as volatility ramped up around the end of the year. So I don't think we are in a particularly tough spot there.

Emmanuel Cau: But if US equities are not a crowded trade, they are certainly priced as if they are. The US looks almost priced for perfection to me. And if you exclude tech, US equities are far more expensive but not much more profitable than Europe.

Venu Krishna: I'll admit that US equity valuations do look quite full. Let's back out big tech. The rest of S&P 500 is in the 90th percentile of forward PE multiples over the last ten years, while the STOXX 600 is in the 46th percentile. Now that is a massive discount. But you mentioned earlier that the equity risk premium is inflated in Europe. It's opposite in the US. Here, risk premium has pretty much never been lower. Actually, it's negative right now.

Emmanuel Cau: That doesn't sound compelling to me, Venu.

Venu Krishna: Maybe. But let's put this in perspective. The US equity premium has fallen through the floor while Treasury term premium has gone through the roof. Yes, there are some deficit concerns in play there, but a strong dollar and outflows from longer dated US government bond funds make me think that it's more due to safe haven demand evaporating as markets price in more growth, more optimistic rate cut. Expectations may not pan out. But remember, only five months ago the fed started strong out of the gate with a 50 basis points cut. So on balance, I believe the world is still looking to the US for growth and what equity investors are paying for. Maybe European stocks are cheap for a reason, a classic valuation trap.

Emmanuel Cau: To be fair, I think it will take time for investors to deploy capital in Europe, and the Equitization is a bigger issue than it is in the US. But to start with less negativity on geopolitics, a shift towards pro-growth domestic policies and diversification away from the crowded US market could be a good starting point and bring more performance chasers in Europe. I also believe that a lot of negativity in China is reflected in European valuations, the sectors and stocks that have dragged the performance of Europe are generally the most exposed to China. We do not expect aggressive policy support or major stimulus, but seeing some signs of stabilization in some parts of the Chinese economy, like the consumer, that could help to.

Venu Krishna: It sounds like there's no shortage of catalysts to keep an eye on, Emmanuel, and I'm sure we'll be both busy in 2025. I look forward to seeing how it all plays out. For now, I invite clients to read my and Emmanuel's latest research on US and European equity strategy available on Barclays Live. And of course, we would also appreciate your five star vote in the 2025 Extel Developed Europe Research Survey, currently under way in the Equity Market Strategy category. Thank you.

Emmanuel Cau: Thank you