Contrary to viewing fiscal constraints as a negative, Morgan Stanley highlights that European banks are positively exposed. Tighter government spending tends to steepen the yield curve, which directly boosts bank profitability. This, combined with low valuations and consistent earnings beats, makes the sector a top pick.
A persistent headwind for European markets is the dual impact of rising Chinese competition and weak demand from China. For the past several years, this single factor has been responsible for a staggering 60% to 90% of all earnings downgrades across the European index, particularly hitting sectors like chemicals and autos.
Morgan Stanley's 2026 outlook suggests a strong US market will create a "slipstream" effect, lifting European equities. This uplift will come from valuation multiple expansion, not strong local earnings, as investors anticipate Europe will eventually benefit from the broadening US economic recovery.
The real investment case for AI in Europe is not in creating foundational models but in adoption. The continent's vast 'old economy' index has significant potential for productivity gains. As AI's return on investment becomes clear, Europe could be re-rated as a major beneficiary of AI adoption, capitalizing on its large industrial base.