European investors are pinning hopes on a German spending surge to reignite the region’s equity markets in 2026, as European stocks continue to lag U.S. markets. After a strong first-half rally in 2025, European equities have struggled to maintain momentum, with flows slowing from $86 billion to $23 billion over the past six months, according to EPFR data tracked by Barclays.

The revival of so-called MEGA (“Make Europe Great Again”) trades—driven earlier by a combination of EU defense spending, Germany’s fiscal reforms, and U.S. tariff concerns—is now contingent on Germany delivering stimulus with tangible impact on the economy and equity markets.

German Spending: Key to European Stock Performance

Germany, which represents roughly 25% of the EU’s GDP, overhauled its fiscal rules in March 2025 to boost infrastructure and defense spending. However, analysts note that much of the new spending has gone toward day-to-day expenses rather than long-term infrastructure investments, which could have a more durable effect on the economy and stock valuations.

Barclays economists point out that while infrastructure spending will accelerate in 2026, social spending has been rising faster this year, limiting the immediate impact on market sentiment. Ross Hutchison, head of eurozone market strategy at Zurich Insurance Group, said:

“Germany’s budgetary plans are not as ambitious as we would have liked. Execution risk is also high, given Germany has underdelivered on investments in recent years.”

German equities have risen 20% in 2025 but have plateaued in the second half, and European stocks overall trade at roughly a 35% discount to U.S. rivals relative to forward earnings, offering scope for inflows if sentiment improves.

European Market Outlook

A rebound in STOXX 600 earnings following a contraction in 2025 could provide additional momentum. Investors are also watching geopolitical developments, particularly a potential Ukraine peace deal, which could reduce energy costs and create opportunities for reconstruction efforts estimated at over $500 billion in the next decade.

Despite these potential catalysts, European equities are expected to continue underperforming U.S. stocks, in part due to the latter’s greater exposure to the AI boom and stronger investor flows. Four of the six largest U.S. and European investment banks predict Europe will lag U.S. markets in 2026.

Euro Exchange Rate: Dollar Dependence Remains

The euro has gained 13% against the U.S. dollar in 2025, its strongest annual performance since 2017, but has largely plateaued since June. The euro’s future trajectory depends on a combination of German stimulus execution, European Central Bank policy, and U.S. dollar movements.

Goldman Sachs forecasts euro gains largely driven by dollar weakness amid a slowing U.S. economy and potential Federal Reserve rate cuts, projecting a level of $1.25. Conversely, UBS expects limited dollar weakness and a potential drop to $1.14. Andreas Koenig, head of global FX at Amundi, emphasized:

“Most of the time FX is more dominated by what happens in the U.S. and what the Fed does, and I think we are still there.”

Conclusion

For European markets, the revival of MEGA trades will depend heavily on Germany delivering effective fiscal stimulus, progress on Ukraine reconstruction, and stable euro performance. While valuations and low expectations leave room for upside, investors will be closely monitoring whether structural reforms and spending plans can translate into sustained growth and equity market gains in 2026.