(Bloomberg) — This was a historic quarter for European stocks. Investors are now wondering if there will be an encore.

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For years, there was little reason to look beyond the US, where soaring tech giants and relentless economic strength fueled an era of market dominance. But doubts have grown around the US exceptionalism trade due to uncertainty from Donald Trump’s tariff policies and government job cuts — and Europe is emerging as a beneficiary.

The pan-European Stoxx 600 outpaced the S&P 500 by nearly 17 percentage points this quarter in dollar terms — a record outperformance. The rally — a surprise amid expectations that Trump’s “America First” agenda would have the opposite effect — has left both skeptics and bulls asking if this is the start of a lasting revival, or just a fleeting moment.

Buyers were initially attracted by the value on offer in notoriously cheap European equities after years of underperformance. Then, Germany’s fiscal plans lifted the mood around the outlook for the economy and corporate earnings.

“We have been waiting for a long time for this sentiment to change,” said Daniel Nicholas, a client portfolio manager at Harris Associates, whose firm has had a large exposure to the region since the euro-area debt crisis. “European companies have been mispriced.”

Germany’s plan to ramp up defense and infrastructure spending has changed the landscape for investors, who spent the first three months of the year unwinding underweight positions. Bank of America Corp.’s March fund manager survey showed they were a net 39% overweight in Europe, the most in almost four years.

Regional stock funds have seen $21 billion of inflows this year through mid-March, according to EPFR Global.

Germany has been the big winner. Its benchmark DAX Index has jumped 13%, and recent exchange-traded products data from iShares show flows are largely concentrated in the country’s assets.

“The rally can go on for a bit. On a three-to-six month basis, Europe is attractive,” said Jean Boivin, head of the BlackRock Investment Institute.

The shift has also turbocharged the euro, which pushed close to $1.10 earlier in March. It had slumped toward parity as recently as February, but now investors are positioning for a much stronger currency over the medium term. Ales Koutny at Vanguard International says $1.20 is a “very real probability” by year-end, depending on Trump’s tariffs.

There’s also room for bonds to reprice further as investors charge more to absorb the surging supply from Germany. Aviva Investors and BNP Paribas SA have floated the possibility that 10-year bund yields will hit 4%, a level not seen since the global financial crisis in 2008.

There are still huge risks from Trump’s actions, though so far the US appears to have taken the brunt, setting off a torrid period for its assets. In addition, the hugely popular artificial intelligence trade has wobbled. The Nasdaq 100 and S&P 500 have slumped into a technical correction as a result.

In the global rotation that ensued, Europe not only emerged as an attractive undervalued alternative, but manged to mostly withstand the downward pressure from the US slump, a rare testament of intrinsic strength.

“When investors are trying to diversify away from the Trump risk, Europe is one of the main beneficiaries,” said Daniel Murray, deputy chief investment officer at EFG Asset Management. “You’re always looking for extremes in valuations, in positioning, in sentiment, and you’re looking for a catalyst in why that may change. And I don’t think we’re there yet. This can run further.”

While it’s far from the extremes of US-like FOMO, Europe’s outperformance has been so strong that the financial industry is abandoning caution, hiking targets and looking to the upside.

Nearly half of the strategists in a Bloomberg survey have raised their forecasts for the Stoxx 600 since last month, with several pointing to policy shifts improving the profit outlook.

The big sectoral winner has been defense, and companies such as Rheinmetall AG have seen significant gains. A Goldman Sachs Group Inc. basket of defense stocks has jumped 70% this year, and investors are paying a premium of 100% versus the broader market as they bet that Europe’s rearmament will boost earnings.

Firms set to benefit from investments earmarked for modernization projects and a potential rebuilding effort in Ukraine have started to gain traction. Goldman analysts have highlighted materials, electrical power equipment, utilities and industrials.

But for all the headlines about Europe’s stunning start to 2025, the rally is concentrated in a handful of areas, and hugely dependent on governments following through on their fiscal plans.

Other historic pillars of Europe, like automakers and healthcare, are underperforming the wider market. And the speed at which policy changes will translate into earnings is unclear.

“The jump in equity baskets of construction, materials stocks is likely a flash in a pan,” says Ariane Hayate, a fund manager at Edmond de Rothschild Asset Management. “From my conversation with managers in the sector, it is quite unlikely that the Ukraine reconstruction effort, when it comes underway, will translate into meaningful earnings.”

There’s also work to do if the region wants to encourage investors to stick with it for the long term, including a unified approach to fiscal policy — a major hurdle.

Europe’s somewhat fractured capital markets are also an issue. According to Boivin at BlackRock, if 2% to 5% of global allocations shifted out of the US, “that would create liquidity issues and I don’t think Europe right now has the depth to absorb that.”

Other challenges persist. Escalating trade tensions could introduce volatility, and the outlook for China — crucial for Europe’s exporters — remains unclear. Additionally, the rise in bond yields is a reminder that expansive fiscal policies come at a price.

For now, many are choosing to see the bright side.

“In more than 30 years in markets, I have rarely seen such a sudden surge in Euro-optimism,” said Holger Schmieding, chief economist at Berenberg. “Is the Europhoria justified? My answer is nuanced. Yes and yes – but not in every respect. The more positive outlook for Europe makes sense. But as usual, the sudden swing may be a little overdone in some cases.”

–With assistance from Sagarika Jaisinghani, Michael Msika and Alice Gledhill.

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