European markets enter 2026 on a positive note, with recession fears reduced, inflation close to central‑bank targets and fiscal packages beginning to filter through to the real economy, while several European assets still trade at more moderate valuations than their US peers.
But as valuations approach two-year highs, equity investors are becoming more discriminating, weighing improving growth prospects against higher bond yields and geopolitical risks. The AI narrative that has shaped markets in 2025 is set to remain a dominant force in 2026, with investors increasingly focused on where adoption can translate into earnings. We have identified five signals to watch for clues.
Europe’s Growth Outlook: A Gradual Recovery, Not a Boom
After several years of weak and uneven expansion, with EU27 growth hovering around 1% in 2024 and only gradually improving through 2025 amid energy shocks, high inflation, tighter monetary policy, and US tariff tensions, Europe is entering 2026 with a more stable – if still modest – growth outlook.
The European Commission projects that real GDP in the EU will grow by 1.4% in 2026 and 1.5% in 2027, with the euro area on a similar but slightly lower path, driven primarily by private consumption and investment. Large member states such as Germany, France, Italy and Spain are all expected to expand.
“The global environment remains challenging, but a resilient labor market, improving purchasing power and favorable financing conditions are set to support moderate economic growth,” the EU said in its autumn forecast.
Fiscal policy and household demand are emerging as key growth drivers for Europe in 2026, as policymakers increasingly acknowledge that demand will need to come from within the bloc rather than from exports. A modest loosening of the euro area fiscal stance – led by Germany’s expansionary budget plans, including higher defense and infrastructure spending – is set to support domestic activity, while easing inflation and rising wages are expected to lift real incomes and underpin consumer spending.
European Stocks: Where Investors Should Focus
European equity markets enter 2026 against a more supportive macroeconomic backdrop. Growth expectations have improved modestly, inflation risks have shifted to the downside, and greater clarity on trade conditions – despite lingering tariffs – has reduced a key source of uncertainty for investors. At the same time, fiscal support is becoming more visible, with parts of Germany’s infrastructure fund set to be deployed and higher defence spending across Europe about to provide a tangible boost to industrial activity.
These factors help explain why European equity valuations have recovered from the selloff triggered by US tariff announcements in April 2025. “European markets now trade at just a 1% discount to our fair value estimate, a smaller discount than the market has traded at for much of the past two years,” according to Michael Field , Morningstar’s chief European markets strategist.
With European equities trading at only a small discount to fair value, however, valuations now capture much of the good news, leaving less incentive for investors to buy now, he adds.
Euro vs USD: From Undervalued to Stabilising
Tariffs aren’t the only headwind European exporters are facing as markets move into 2026. Exchange rates are also playing a role: Euro strength can weigh on exporters by eroding competitiveness and limiting the translation boost from overseas earnings, favoring companies with greater exposure to domestic demand.
After having benefited in 2025 from bouts of dollar weakness, the euro enters 2026 at around 1.16 against the dollar, priced well below its long-term fair value of 1.20, according to Morningstar’s currency research. For much of the past decade, the common currency traded significantly below its fair value against the US dollar, weighed down by monetary policy divergence and concerns over the cohesion of the currency union.
“While the eurozone faces its own structural challenges, the currency’s relative stability, institutional credibility, and external balance sheet strength are helping increase its share in portfolio allocation decisions worldwide,” says Michael Diamantopoulos, associate director fixed income and currency at Morningstar. “Despite its appreciation in 2025, our valuation metrics suggest the euro remains moderately undervalued against the US dollar.”
Future moves will be driven less by valuation catch-up and more by macro and policy dynamics, according to Morningstar’s “EUR Conviction Update”. ECB credibility remains a relative strength as inflation has moved back toward target and policy divergence with the Federal Reserve has become less pronounced, reducing downside risks for the currency. At the same time, Germany’s fiscal expansion supports domestic growth but also implies increased sovereign bond issuance, keeping yields elevated. While the euro area’s external balance remains solid, rising trade fragmentation and higher US tariffs pose risks, making capital inflows into productive investment a key factor in sustaining the currency’s resilience in 2026, according to the report.
For European investors, a stronger euro makes new dollar investments cheaper, but also reduces returns in euro on existing dollar exposures.
Beyond Europe’s Energy Crisis
Amidst the stabilizing macro environment, the energy sector shifts focus from crisis response following the war in Ukraine to long term transformation. Russia was a main supplier of pipeline gas to Europe, before sanctions following its full-scale invasion of Ukraine.
Natural gas prices have fallen markedly from their peaks in 2022 and are currently shaped by ample supply, subdued short term demand and the absence of major disruptions, even if short-term quotations remain sensitive to weather and geopolitics.
Continental Europe’s benchmark TTF natural gas contracts are trading around EUR 30 per megawatt-hour as of mid-January, the lowest levels since spring 2024. While storage levels are lower than in previous years, “liquefied natural gas imports as well as pipeline deliveries – especially from Norway – continue to secure supply,” says Josephine Steppat, analyst at energy information provider Montel. “At present, we see no signs of structural shortages, provided there are no unexpected geopolitical disruptions or episodes of extreme cold.” Competition with Asian countries for LNG could potentially push prices higher, particularly if temperatures fall sharply and storage levels decline further, she adds.
US LNG is set to become one of Europe’s key sources of imports
Josephine Steppat, Montel
Strategically, the EU decision to phase out Russian gas imports by November 2027 is crucial, she adds. “Against this backdrop, US LNG is set to become one of Europe’s key sources of imports, and we are already seeing an increase in trading volumes of US LNG. As a result, global LNG prices are increasingly becoming a decisive driver of European gas prices.”
AI and Power Demand in Europe: What 2026 Means for Investors
Despite growing demand, power supply also looks sufficient this winter and in the years ahead, Montel’s Steppat adds. While electricity demand is set to grow over the next decades, driven in part by AI needs, Montel doesn’t foresee structural power shortages.
Average European power prices are likely to decline in 2026, Montel’s Steppat says. “In the short term, we see a tendency towards falling electricity prices in Europe. This is mainly due to declining gas prices, which are also visible in forward markets for the coming year. Since electricity prices in Europe are strongly influenced by gas prices, this development provides some relief.”
However, significant price differences persist across European countries. While wholesale prices in South‑Eastern Europe are comparatively high, Nordic countries and the Iberian Peninsula have lower average annual prices. Varying taxes and grid fees add complexity to the picture for industrial users. Some high-priced countries, including Italy and Germany, are subsidizing or planning to support industrial power prices in 2026, subject to European Commission approval.
“Overall, we do not expect structural bottlenecks in Europe’s electricity supply. Based on national expansion targets, sufficient generation capacity should be created across Europe to cover the additional demand from AI as well,” Steppat says. The prerequisite is a more flexible system, with storage to absorb surpluses and release power when needed, and demand that can shift in response to variable renewable output.
This year, power demand in the EU27 plus Norway, Switzerland and UK is expected to rise by roughly 7% compared to 2025, with growth rates of 2.8% on average for the next 15 years.
The author or authors do not own shares in any securities mentioned in this article. Find out about
Morningstar’s editorial policies.