Podcast Summary: Thoughts on the Market

Episode: Special Encore: What’s Driving European Stocks in 2026
Date: January 30, 2026
Host: Paul Walsh (Head of Research Product, Morgan Stanley Europe)
Guest: Marina Zavolok (Chief European Equity Strategist)

Episode Overview

This special encore episode explores the key factors shaping European equity markets as we head into 2026. Paul Walsh and Marina Zavolok dive into the persistent valuation gap between European and U.S. equities, the recent narrowing of this discount, sector-specific opportunities and challenges, and the structural trends fueling bull and bear cases for European stocks. The discussion includes timely insights on flows, earnings growth, sector dispersion, and the strategic impact of themes such as AI adoption and M&A activity.

Key Discussion Points and Insights

1. European vs. U.S. Equities: Shifting Dynamics

Timestamps: 00:16–04:52

• Recent Outperformance of Europe:
  • Since the last U.S. elections, European equities outperformed U.S. equities in constant currency terms (00:51).
  • "I think it would surprise most people to know that... European equities have outperformed U.S. equities since U.S. elections." — Marina Zavolok [00:55]
• Widening Discount Turning Point:
  • For a decade, European equities traded at an ever-widening valuation discount to the U.S. (next 12m PE).
  • On December 31st, 2025, European equities broke through the top end of that discount range—a rarity signifying a possible trend reversal (01:25).
  • "For the first time in 10 years, European equities have broken the top of that discount range." — Marina Zavolok [01:24]
  • Historic pattern: When this breakout occurs, the discount tends to narrow, not in a straight line, but over time, heading toward single-digit percentages.
• Flows and Diversification:
  • Increased inflows into European equities echo early 2025, driven both by diversification needs and relative valuations (03:00–03:36).
  • U.S. market remains large and concentrated; investors are seeking alternatives.
• Sustainability of the Trend:
  • While optimistic about narrowing the performance gap, Marina remains cautious about full-year European outperformance due to lower projected earnings growth:
    • "I have 4% earnings growth forecast... Our U.S. equity strategists... have 17% earnings growth." — Marina Zavolok [03:43]
    • Base case is a narrower performance gap, not outperformance (04:33).

2. The Bull Case for Europe: Structural and Thematic Drivers

Timestamps: 04:52–07:13

• AI Adoption:
  • A quarter of the European index are AI-leading adopters showing significant earnings and return outperformance—both vs. European peers and U.S. equivalents.
    • "That gap of earnings outperformance is growing and becoming more meaningful every time that we update our own chart... it's more difficult for investors to ignore that group of stocks." — Marina Zavolok [05:19]
  • European AI adopters still trade at a ~27% discount to U.S. equivalents; broadening adoption could drive further gains.
  • Europe’s index skews to "AI adopters" rather than "enablers", with productivity and demographic benefits ahead.
• M&A Activity:
  • Rising M&A activity in Europe, aided by easing Competition Commission rules and corporate releveraging from lows (06:10).
• Structural Reforms:
  • Policy moves such as the emerging Savings and Investment Union, including pensions reform (especially in Germany), could act as longer-term catalysts (06:57).
    • "We're starting to see it in Germany." — Paul Walsh [07:01]

3. Investment Strategy: Stock Picking Over Style Boxes

Timestamps: 07:13–10:25

• Cyclicals vs. Value vs. Quality:
  • "It's not really about any of those things. What we're going to see is stock level dispersion continuing to rise." — Marina Zavolok [07:19]
  • Europe is increasingly a stock picker’s market, with under-the-surface alpha opportunities outpacing index-level strategies.
• Morgan Stanley’s Analyst Top Picks:
  • These have outperformed both the Europe index and the S&P:
    • "Since inception of Top picks in 2021, European top picks have outperformed the S&P free float market cap weighted by over 90 percentage points... by 17 percentage points in the last year." — Marina Zavolok [08:05]
• Preferred Sectors:
  • Banks: Top of models; attractive to non-specialist investors.
  • Defense: Structural rearmament trend; seasonally strong January–April.
  • Powering AI Thematic: Recent upgrade to Utilities; robust incoming investor interest.
  • Semiconductors:
    • Paul Walsh relays that global wafer fab equipment spend is expected to grow double digits in 2026–2027—especially in semi cap and memory, tied to an ongoing "memory super cycle" underpinned by AI inference demand.
    • "The outlook for memory is especially encouraging... set to come from the proliferation of humanoid robots... a global humanoids semiconductor TAM of over $300 billion by 2045." — Paul Walsh [09:24]

4. Sectors to Avoid: Old Economy & China-exposed Names

Timestamps: 10:25–10:59

• Sectors at the bottom of their models include:
  • Autos, chemicals, luxury, transport, food & beverage—mainly old economy cyclicals with high China demand or competition exposure.
  • "Many of these... have high China old economy exposure... not seeing really a demand pickup... facing ever rising China competition." — Marina Zavolok [10:50]

5. Key Takeaway: It’s Complicated—Balance Matters

Timestamps: 10:59–11:12

• The cyclicals vs. defensives debate oversimplifies the current European landscape; nuanced stock and sector selection is vital.

Notable Quotes

• "For the first time in 10 years, European equities have broken the top of that discount range." — Marina Zavolok [01:24]
• "I have 4% earnings growth forecast... Our U.S. equity strategists... have 17% earnings growth." — Marina Zavolok [03:43]
• "What we're going to see is stock level dispersion continuing to rise." — Marina Zavolok [07:19]
• "Since inception of Top picks in 2021, European top picks have outperformed the S&P free float market cap weighted by over 90 percentage points." — Marina Zavolok [08:05]
• "The outlook for memory is especially encouraging... the proliferation of humanoid robots... over $300 billion by 2045." — Paul Walsh [09:24]

Timestamps for Important Segments

• [00:16] The valuation gap and hidden outperformance of European equities
• [03:00] The role of flows and sustainability of the trend
• [04:52] The bull case for Europe: AI adoption, M&A, structural reforms
• [07:13] Investment style: Stock selection, sector picks
• [09:06] Semiconductor sector outlook
• [10:25] Sectors to avoid: Autos, chemicals, luxury, old economy
• [10:59] Final thoughts: Beyond simple style boxes—nuanced selection

Conclusion

This episode provides a data-driven, forward-looking perspective on the forces shaping European equities going into 2026. While the valuation discount with the U.S. is narrowing, underlying sector and stock dispersion means alpha opportunities abound—but only for those able to look past simple cyclical or defensive splits and engage with Europe’s evolving thematic and structural trends.