From outcast to darling! After the AI pullback, how did European stocks suddenly stage a comeback?

Title context: From outcast to darling! After the AI pullback, how did European stocks suddenly stage a comeback? Text: As global investors seek to reduce their exposure to artificial intelligence (AI), Europe's diversified stock market has suddenly become one of the most attractive trades. Not long ago, the pan-European Stoxx 600 was lagging behind, with the market wary of its vulnerability to upside oil price shocks and its lack of leading tech names in the AI wave. Now, Europe's combination of solid industrials, banks and defensive leaders, plus a host of commodity companies, is demonstrating its value. On Thursday, the Stoxx 600 withstood the deepest pullback in the S&P 500 since April 2025 and is on track for its strongest quarterly outperformance versus global equities since the start of last year (when Germany first announced a large-scale fiscal stimulus plan). "Given the policy stalemate, this indiscriminate market selloff has gone too far, though it will take time for sentiment to stabilize. Europe is relatively well positioned to benefit, especially if the tail risk from oil prices fades," said Emmanuel Cau, head of European and Asia-Pacific equity strategy. In fact, even before the U.S. midterm elections, Europe's strong earnings growth was already benchmarking against its peers on the other side of the Atlantic and enhancing its appeal. But as a Democratic sweep of Congress heightened concerns about the risks of the AI trade, investors urgently needed a change of direction. Europe has become the destination of choice for capital. The "blue wave" set off by U.S. voters pushed Treasury bonds higher as the market bet that Democrats would constrain the Trump administration's tax and spending plans. That also revived the outlook for the many clean energy stocks listed in Europe. The rotation into defensive sectors once provided most of the impetus, but recently the entire market has been rising. This contrasts sharply with the market characteristics of the past five years and lays the foundation for the index to close 2026 on a strong note. "In October the market favored low-volatility bond substitutes such as health care and food and beverages, but investors will now chase cyclical stocks that are more sensitive to falling interest rates," said strategists at Kepler Cheuvreux led by Arnaud Girod. "This could help spark a year-end rally." The midterm elections cleared the way for the market. This week's plunge in oil prices shows investors have begun pricing in a higher probability that the Iran war will end soon. Sectors that suffered the heaviest profit-taking in recent months, such as banks and miners, as well as consumer discretionary stocks that have lagged this year, are all getting some breathing room. That said, risks remain in the region. The recent surge in bond yields and credit spreads is still fresh in investors' memories, and the political situation in France ahead of the April presidential election remains a concern. Meanwhile, if oil prices slide, the standout earnings growth may be called into question. In addition, the region's economic growth rate may remain sluggish next year at 1.3%, compared with 2.2% in the U.S. and 3.3% globally. But that may still be enough to support a stronger market. "We find that the impact of global sentiment is more important than purely domestic growth," said Goldman Sachs strategists including Sharon Bell. "More than half of the Stoxx 600's revenue comes from outside Europe." Earnings growth is the biggest surprise. The market had expected European earnings to accelerate steadily and catch up in 2027 or 2028 with gradually slowing U.S. profit growth. But Europe's recovery has been far faster than expected. Third-quarter reports show European corporate profits rebounding sharply, with momentum comparable to that of U.S. stocks. Earnings per share grew about 32% year on year in both regions, but European earnings beat expectations by 9.2 percentage points, higher than the 7.6 percentage points for U.S. stocks. "Europe has delivered another strong quarter of earnings, reinforcing our view that the region's profit recovery remains on track," said Matthew Gilman, head of European equity strategy in the chief investment office at UBS Global Wealth Management. "Revenue growth continues to pick up, margins continue to repair, and earnings revisions are above the seasonal norm." Gilman said that although investment-related demand remains the main engine of growth, supported by AI, electrification and defense spending, earnings improvement is spreading to other areas. "As a result, we believe the earnings outlook is more structurally balanced and no longer overly dependent on a few themes." Admittedly, energy stocks accounted for a large part of last quarter's growth, but profits rose in every sector. And although falling oil prices will erode index-level earnings per share, their positive impact on market sentiment may continue to lift share prices. Lower energy costs will also ease the burden on consumers and may slow the pace of rate hikes by the European Central Bank or the Bank of England. In the short term, signs of market overheating have emerged, with nine sectors already in overbought territory. However, the broad index has not yet shown similar signals, and foreign investors' overall allocation to Europe remains low. Bank of America's fund manager survey last month showed global investors still maintained an 8% underweight in Europe, meaning there is room for further rotation of funds. "We have clearly shifted into risk-on mode," said Florian Roger, head of the chief investment office at BNP Paribas Corporate & Institutional Banking. "We are overweight Europe and believe several sectors could drive further gains."