European Equity Strategy: Moderating Rhetoric, Stabilizing Markets, Earnings Reset

In a new presentation from Citi Research, a team led by Head of European Equity Strategy Beata Manthey looks at an “earnings reset” under way for European equities. After initially announcing a 90-day pause in Liberation Day U.S. tariffs, the White House’s trade stance has seemingly continued to moderate. Key sectors, such as tech, remain exempt from tariffs altogether; negotiations have begun with Japan; and officials have signaled potential de-escalation in the U.S.–China trade spat. Subsequently, markets have stabilized, with the Stoxx 600 already paring back half of its initial losses. While measures of implied equity-market volatility remain elevated in both Europe and the U.S., these readings are well below recent highs.

Analysts have already started to put through earnings per share (EPS) downgrades, with our proprietary global Earnings Revision Index (ERI) for Europe recently hitting “recessionary” levels of around –60%. This is the lowest reading since the pandemic, and a level only seen during past crises. Historically, ERI readings around these levels almost always translate into a subsequent decline in EPS. But severely negative ERI readings also tend to be a contrarian buy signal, with European equities delivering ~25% returns on average 12 months later and Cyclicals outperforming Defensives. The most beaten-up Cyclical sectors in Europe include Autos, Basic Resources, Tech and Luxury Goods.

Europe’s first-quarter reporting season is still in its early stages, but so far 61% of companies have exceeded EPS expectations, a pace slightly above historical average. However, first-quarter forecasts were lowered heading into the quarter, market reactions to earnings have been indicative of low expectations, and forward-looking guidance remains tilted negative.

More EPS downgrades are likely from here, with proposed tariffs a drag on growth. The bottom-up consensus has converged down to our once relatively bearish top-down 2025 EPS growth forecast of +5%, a view we maintain for now.

Key investment themes

We also look at 10 key investment themes we see at work, summarized briefly here:

1. Fading U.S. Exceptionalism: U.S. equities consistently outperformed global peers following the Global Financial Crisis, but these dynamics could be changing. Investors have shown signs of shunning other U.S. assets, with the dollar weakening and U.S. Treasury yields rising.

2. From Tariff Risks to Recession Risks: The U.S. effective tariff rate could reach heights not seen in a century, with our economists’ simulations suggesting tariffs will weigh appreciably on U.S. and global growth. Direct impacts of tariffs could take global EPS growth to low single digits this year, with rising prospects for a recession skewing risks to the downside. In the U.S., higher input costs could compress margins. Based on announced tariff levels, we estimate a potential ~3 percentage-point drag on European earnings growth this year, vs. +7% consensus forecasts. Should tariffs lead to a more meaningful economic slowdown, European EPS growth could come in flat to down this year.

3. “Whatever It Takes” 2.0: Defense spending plans are expected to add 2% to 2.5% to cumulative European GDP growth until 2029. This, combined with a broader infrastructure stimulus from Germany, could add 3% extra EPS growth per annum.

4. Cease-Fire/Lower Energy Prices: Our analysts think European gas prices could fall 50% through 2028.

5. Broader Markets?: Markets narrow for two reasons: Growth is scarce, so markets pay up for select growing names, and/or there’s a new theme everyone wants to be part of. These dynamics have supported U.S. equities in the era of U.S. exceptionalism, but they could be shifting going forward. EPS growth could broaden, with the gap in EPS growth between the “Mag 7” and the “Other 493” expected to narrow to single digits. The growth profiles of the “Other 493” and the broader European market looks similar, but there’s less need to pay up for it.

6. China as a Key Swing Factor: U.S. tariffs on China may have already reached a prohibitive level for ~80% of China’s goods. We recently cut our China growth forecast to +4.2% in 2025 from +4.7% year over year. China’s domestic stimulus could be brought forward, with the focus likely on consumption. 

7. Rates Debate: The initial move higher in the U.S. 10-year yield around rate cuts bucked historical trends, though equities followed a familiar pattern. Even after cuts, U.S. rates could settle in a range favorable to Cyclical markets outside the United States. Developed-markets equity risk premium (ERP) is still in a low regime but has been rising in recent months. Recent stock-market weakness will be reflected in higher ERP estimates. Increasing developed-markets ERP has been driven by the U.S., while European ERP has been flat to down.

8. EPS — What’s Priced In?: The U.S. market has moved from “priced for perfection” to priced in line with analysts’ forecasts. Europe, Japan and emerging markets are now pricing in downgrades. 

9. The USD: A weaker U.S. dollar tends to favor the rest of the world over U.S. equities, but can weigh on rest-of-the-world EPS.

10. Corporate Actions: The distribution yield (dividends plus buybacks) for the Stoxx 600 is now ~4%, compared to ~3% for the S&P 500. Stoxx 600 buybacks declined ~30% in 2024; we forecast another buyback contraction of 5% to 10%, bringing us to around pre-pandemic highs.