Europe sector review – a stronger market, but not an easy one

European markets have delivered strong returns during the past year, but those gains have not been evenly spread. A relatively narrow group of sectors and companies has led the market, creating a more challenging backdrop for some active managers and a useful reminder of how quickly investment styles can move in and out of favour.

Winners have included Banks, which benefited from higher interest rates and improved profitability, and technology companies have been supported by enthusiasm around artificial intelligence (AI). Utilities and industrial businesses have also benefited from expectations of increased investment in infrastructure, energy security and electrification.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, ask for financial advice. Investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Why market leadership has mattered

During the 12 months to the end of August 2026, the broader European market, as measured by the MSCI Europe ex UK index, has delivered strong returns of 20.32%*. However, the greatest returns were concentrated in a relatively small number of sectors and companies. As always, past performance is not a guide to future returns.

Banks were among the strongest-performing areas of the market, returning almost 46% during the year. Technology stocks also delivered strong gains, and utilities outperformed the broader market. Mining produced one of the most striking performances, rising 89.19%, although it was considerably more volatile along the way. By contrast, consumer-facing sectors struggled.

The concentration of returns in some areas has had notable implications for investors and active fund managers.

Many active fund managers, particularly those focused on high-quality businesses, have found it difficult to keep pace with a market increasingly driven by a narrower group of cyclical and economically sensitive sectors.

This is not unique to Europe. Similar dynamics have played out across several global markets in recent years.

Quality-focused managers typically favour businesses with durable competitive advantages, strong balance sheets, resilient cashflows and more predictable long-term growth prospects. They often avoid companies whose fortunes are closely tied to the economic cycle.

During the past year, investors have tended to favour more cyclical parts of the market.

Financial companies have benefited from higher interest rates, and industrial and infrastructure-related businesses have been supported by expectations of increased government spending. These aren’t areas where quality-focused funds tend to be heavily invested.

As a result, investment styles have produced different outcomes. European value stocks returned almost 25% during the year, ahead of growth stocks, which returned 16.10%, although still a strong positive return during the period.

For investors, this is a reminder that a rotation in investment styles can create significant performance differences between funds, even when managers remain disciplined and continue to follow their investment process. Different styles will fall in and out of favour over time, and periods of underperformance don’t necessarily indicate that a manager’s approach is no longer working.

What this has meant for European funds

These market dynamics are reflected in European fund performance.

On the Wealth Shortlist, the Legal & General European Index fund was among the stronger performers during the year. It aims to track the performance of the broader European market, so it fully participated in the strong performance of the companies and sectors that drove market returns. As with many index funds, it may use securities lending, which can boost returns but also add risk.

Performance among active funds was mixed.

BlackRock European Dynamic returned 14.33%, and Barings Europe Select returned 13.72%. BlackRock is relatively concentrated, meaning that each holding can have a greater impact on performance, both positively and negatively. Barings focuses on small and medium-sized companies that did not perform as well as some of the biggest firms. They’re expected to offer greater long-term growth potential, though they’re higher-risk.

Polar Capital European ex UK Income, which is a more conservative fund that tends to hold up better in weaker markets rather than shoot the lights out in stronger ones, returned 10.75%. The fund invests in a relatively concentrated number of companies and can also use derivatives, both of which increase risk, although these are part of the way that the managers run the fund.

Although these returns lagged the broader market, the reasons are important. Some active managers held less in the strongest-performing areas either because those companies don’t fit their investment process or because valuations (a measure of whether a company’s shares reflect its future potential) had already risen to levels that they found less attractive.

That discipline can be a headwind when markets become concentrated, but it could help if market leadership changes or expectations become too optimistic.

For this reason, we place emphasis on understanding whether fund performance remains consistent with a manager’s philosophy and process rather than focusing solely on whether a fund outperformed in a shorter period.

What we’ve been focusing on

One of the main pieces of European research activity for our team recently was the addition of BlackRock European Dynamic to the Wealth Shortlist. The fund was added following a detailed review of the manager, investment process, team and long-term performance potential.

The fund provides investors with access to larger European companies through a flexible, growth-oriented investment approach. Although the managers have a growth bias, they’re not constrained to a narrow style or part of the market. Instead, they seek opportunities wherever they believe that future earnings growth is not fully appreciated by other investors. In a market where leadership has been narrow and style rotations have been significant, we think that this flexibility could be useful.

We’re also impressed by the depth of BlackRock’s European equities team, the breadth of research resources available to them and a culture that encourages constructive challenge and debate. These factors give us confidence that the team is well positioned to identify investment opportunities.

Why investors are watching Germany

Politics is rarely the most important driver of long-term investment returns. However, the AfD’s strong result in a recent German state election has drawn attention to the pressure on Europe’s largest economy and the more fragmented political backdrop facing policymakers.

Germany has faced a difficult few years. Higher energy costs, weaker industrial activity and slowing global trade have all weighed on growth. The AfD’s stronger showing underlines growing voter dissatisfaction and the pressure on mainstream parties to respond to Germany’s economic challenges.

Expectations of higher government and investment spending, particularly in infrastructure and defence, could remain relevant for parts of the European market exposed to those themes.

This creates both opportunity and risk.

Share prices can rise before any economic benefits are realised, and companies exposed to these themes could face headwinds if spending plans prove difficult to implement or investor expectations become too optimistic.

Why higher-for-longer rates matter for Europe

The European Central Bank (ECB) was also in focus this month, raising interest rates by a further 0.25% to 2.50%.

The message from central banks can sometimes matter as much as the rate decision itself. The ECB warned that inflation is likely to remain above its 2% target for longer than previously expected. Rising energy prices, geopolitical tensions and resilient economic activity in some areas mean that the ECB now expects inflation to average 2.5% next year and doesn’t expect inflation to return to target until late 2027.

As a result, markets are anticipating additional interest rate rises in the coming months. This is a shift from earlier in the year, when many investors expected central banks to gradually reduce interest rates.

This has implications for different parts of the stock market.

Higher interest rates have been one reason that banks have performed strongly over the past year. Banks typically earn more from lending when interest rates rise, which can boost profitability and improve earnings expectations.

By contrast, higher rates can be more challenging for growth companies. Higher borrowing costs can weigh on expansion plans, and investors also tend to place lower valuations on profits expected further into the future.

On the positive side, the ECB also revised its growth forecasts higher, suggesting that the economy may be more resilient than previously expected. Stronger growth can be supportive for company earnings, though it can also contribute to higher inflation.

That combination can have different effects across the market. Banks and some economically sensitive companies could benefit from resilient growth, and companies more exposed to higher borrowing costs or long-dated profit expectations could find the backdrop more challenging.