Podcast Summary: Thoughts on the Market

Episode: What’s Driving European Stocks in 2026
Date: January 16, 2026
Hosts: Paul Walsh (Morgan Stanley Head of Research Product, Europe) & Marina Zavolok (Chief European Equity Strategist)

Episode Overview

This episode dives into the evolving dynamics of European equities heading into 2026, exploring how Europe's stock performance compares to the U.S., the factors driving current trends, and where investors might find opportunities – or pitfalls – within European sectors. The discussion is rooted in recent breakout performance, the narrowing valuation discount versus the U.S., and a thematic assessment of growth drivers such as AI adoption, M&A activity, and sector-specific insights.

Key Discussion Points & Insights

1. Europe vs. U.S. Equities: A Shifting Landscape

Main Insight:

• European equities have recently outperformed the U.S. in local currency terms since the last U.S. elections—a fact not widely recognized. (00:44)
• The longstanding valuation discount of European stocks relative to the U.S. has begun to narrow for the first time in ten years, potentially signaling a structural shift in performance dynamics.

Notable Quote:

“If you look since US elections, I think it would surprise most people... European equities have outperformed U.S. equities... For the first time in 10 years, European equities have broken the top of that discount range.”
— Marina Zavolok [00:44]

Context:

• Historically, Europe traded at a widening valuation discount versus the U.S. (next-twelve-months PE).
• Since December 31st, 2025, the European discount has narrowed meaningfully, breaking a decade-long pattern.

2. Investment Flows and Sustainability

• Strong recent inflows into European equities, with investors diversifying beyond the concentrated U.S. market. (02:53)
• Trend akin to early 2025, but this time less about reducing U.S. holdings and more about adding European exposure.

Caution:

• The sustainability of this trend is in question—earnings growth for Europe is forecast at 4% versus 17% for the U.S., suggesting Europe may not fully outperform but could continue to narrow the gap. (03:43)

Notable Quote:

“I still struggle to see European equities outperforming the US over the course of the full year... but what you get is a much narrower gap in performance.”
— Marina Zavolok [03:20 & 04:26]

3. The Bull Case for Europe: Thematic Drivers

a. AI Adoption

• A quarter of the European index comprises leading AI adopters, which are demonstrating strong earnings and returns outperformance versus the broader index and their global peers. (05:02)
• These stocks trade at a 27% discount to U.S. equivalents, presenting a significant opportunity as adoption broadens.

Notable Quote:

“At this rate, the second half of this year it’s going to grow to a point that it’s more difficult for investors to ignore that group of stocks.”
— Marina Zavolok [05:06]

• Europe is skewed towards AI adopters rather than enablers—this is important given its need to address productivity and demographic challenges.

b. Mergers & Acquisitions (M&A) and Financial Structure

• M&A activity is rising sharply; eased competition rules and corporate releveraging could catalyze further growth. (06:02)
• Structural reforms such as the Savings and Investment Union are starting to bear fruit, especially with pension reforms in Germany leading the way. (06:50)

c. Sector and Stock Picking Over Style

• Rather than focusing on broad styles (cyclical, value, quality), success comes down to stock-level dispersion: active selection is key as dispersion within sectors continues to rise. (07:06)

Data Highlight:

• Since inception in 2021, Morgan Stanley’s European analyst top picks have outperformed the S&P free float market cap weighted by over 90 percentage points, and by 17 points in the past year alone.

4. Favorite and Least Favorite Sectors

Top Sectors (Morgan Stanley’s Model)

• Banks: Strongest outlook, popular with generalist investors.
• Defense: Beneficiary of Europe’s rearmament dynamic, with a record of strong seasonal outperformance January–April. (08:50)
• Utilities/Powering AI: Upgraded due to thematic and structural drivers related to AI energy demands.
• Semiconductors: Strong global demand for wafer fab equipment, memory supercycle backed by AI inference, and the rise of humanoid robotics, projected at a $300B global market by 2045.

Notable Quote (on semis):

“The outlook for memory is especially encouraging... driven really by AI inference. And... growth longer term... is set to come from the proliferation of humanoid robots.”
— Paul Walsh [09:23]

Sectors to Avoid

• Autos, Chemicals, Luxury, Transport, Food & Beverage:
  • These “old economy” cyclicals are responsible for Europe’s low growth.
  • Many have high China exposure (where demand isn’t recovering) and face intensifying Chinese competition. (10:18)

Notable Quote:

“These are at the bottom of our data driven sector model... simply avoiding these could be very helpful from a growth perspective.”
— Marina Zavolok [10:18]

5. Final Perspective

• The cyclical versus defensive debate is “much more complicated” in Europe for 2026: Stock picking and sector-specific analysis are far more important than broad categorizations. (10:52)

Notable Quotes & Memorable Moments

• On European vs. US discount reversal:
  “...we have broken the top of that discount range. The last couple of times that’s happened in the last 20 years… you narrow all the way to single digit discount.” — Marina Zavolok [01:46]

• On AI adoption:
  “...at this rate, the second half of this year it's going to grow to a point that it's more difficult for investors to ignore that group of stocks.” — Marina Zavolok [05:06]

• On sector selection:
  “Europe is really about stock picking. And the best way that we have at Morgan Stanley to capture this alpha is our analyst top picks which... have outperformed the S&P... by over 90 percentage points since inception...” — Marina Zavolok [07:27]

Timestamps for Key Segments

• 00:44 European equities’ outperformance and discount narrowing
• 02:53 Sustainability of flows, Q1 effect, and earnings expectations
• 05:02 Bull case—AI adoption, M&A, structural reforms
• 07:06 Stock picking, sector dispersion, and top picks
• 08:59 Semiconductor sector and future AI-driven opportunities
• 10:18 Sectors to avoid and reasoning
• 10:52 Complexity of cyclical vs. defensive debate

Takeaway for Investors

European equities are seeing a historic shift in relative valuation and capital flows, but headline earnings growth lags the U.S. Smart sector allocation and granular stock picking—particularly with an eye toward AI adoption, defense, and banking—are poised to be the differentiators for alpha in 2026.