European equity markets have opened 2026 on a euphoric note. The STOXX Europe 600 climbed to a record 596 points, the Euro STOXX 50 hit an all-time high of 5,850, and the UK's FTSE 100 surpassed the psychologically significant 10,000 mark for the first time in its history — a milestone that capped its best annual performance since 2009.
The rally extends a powerful run from 2025, when the STOXX 50 advanced roughly 18% and the STOXX 600 rose 17%, marking the best year for both indices since 2021. European bourses outperformed their US counterparts for the first time in years, driven by a combination of falling interest rates, Germany's fiscal stimulus packages, and a rotation out of richly valued American technology stocks.
What's Driving the Rally
Several structural forces have aligned to support European equities. Defence stocks have been the standout sector, surging more than 3% in the opening days of the year as persistent geopolitical tensions and rising military budgets across the continent funnel capital into the sector. Technology shares have also outperformed, with ASML — Europe's most valuable tech company — jumping 7% in early trading.
European banks remain at the top of analysts' sector models. With the ECB holding rates at 2% and the lending environment stable, banks are benefiting from healthy net interest margins while their valuations still trade at significant discounts to American peers. Morgan Stanley's chief European equity strategist has highlighted banks as the first sector institutional investors ask about when considering European exposure.
Perhaps the most compelling long-term theme is the emergence of European AI adopters. Analysis shows that about a quarter of the European index now consists of leading AI adopters, and this group is delivering increasingly strong earnings outperformance relative to both the broader index and their sector peers. Critically, these companies trade at an average 27% discount to comparable US firms — a gap that investors are beginning to notice.
The Valuation Question
For all the optimism, the strong start to 2026 has pushed European stock valuations toward fair value, according to Morningstar's European equities research. The index now trades at just a 1% discount to estimated fair value — a thinner margin of safety than investors have enjoyed for much of the past two years.
The danger is not catastrophic loss, analysts caution, but rather the ease with which portfolios could slip into the red if markets experience even a moderate correction. During the tariff-driven sell-off of April 2025, European markets briefly traded at a nearly 20% discount to fair value — a buying opportunity that rewarded bold investors for the rest of the year. Today's entry point offers no such cushion.
Where the Opportunities Are
Small-cap stocks remain the most attractively valued segment of the European market, trading at roughly a 30% discount to their fair value estimates. These companies are highly sensitive to macroeconomic conditions, and the improving growth outlook — with eurozone GDP expected to accelerate modestly through 2026 — could be a catalyst.
Consumer defensive companies, including names such as Heineken, Nestlé, and other globally recognised brands, are unusually cheap by historical standards, as are healthcare stocks, which were among the worst performers last year. The sector faces an improving backdrop as the threat of additional US tariffs has eased and enthusiasm around GLP-1 drugs and other therapies has returned.
European utilities also stand out, boasting the highest capital expenditure growth of any sector as the energy transition accelerates. The insatiable demand for power driven by AI data centres has shifted investor sentiment toward the sector, which still trades at wide discounts to US peers.
The Bottom Line
European markets are in a rare sweet spot: recession fears have receded, inflation is near target, interest rates are stable, and fiscal packages are beginning to filter through. But with valuations no longer offering a margin of safety, 2026 will reward stock-pickers over index-huggers. The broad rally is likely over — what follows is a market that demands selectivity.