A Morgan Stanley report suggests European stocks, despite recent outperformance, need AI-driven productivity gains to sustain growth. Their valuation advantage has narrowed, making future profitability and overcoming AI adoption hurdles critical.

European equities may need a stronger improvement in corporate profitability, potentially driven by artificial intelligence (AI)-led productivity gains, to sustain their recent outperformance as their valuation advantage over global peers has narrowed sharply, according to Morgan Stanley Wealth Management.

Valuation Concerns Follow Strong Performance

The report said European stocks have outperformed global equities since the global manufacturing recovery began in November 2025, but the region's valuation discount has narrowed considerably, increasing the importance of earnings and productivity gains going forward.

Since November 2025, the MSCI Europe Index has outperformed the MSCI ACWI Index by 2.2 percentage points and the MSCI USA Index by 4.8 percentage points in US dollar terms. However, its 12-month forward price-to-earnings discount to the global index has narrowed from 24 per cent in October 2025 to nearly 10 per cent by July 2026, close to its long-term average, the report said.

AI-Led Productivity Gains Seen as Key

"European equities' next leg higher may lie in AI-led productivity gains," Morgan Stanley said, noting that Europe's knowledge- and labour-intensive operating costs are relatively high.

The report said the combined selling, general and administrative expenses and research and development costs of companies in the MSCI Europe Index are just above 18 per cent of revenue, about one percentage point higher than the MSCI ACWI Index. Closing this gap, all else equal, could eliminate nearly half of Europe's current operating-margin gap, it said.

Hurdles to AI Adoption

However, converting this potential into actual productivity gains could prove challenging. The report flagged labour-governance and regulatory requirements, shortages of AI skills and legacy technology and data systems as key constraints to faster AI adoption in Europe.

Sector-Specific Challenges

European banks, which have been a major driver of the region's recent market performance, may also need efficiency gains to sustain profitability. Their return on equity has risen to around 13 per cent, about 800 basis points higher than five years ago, but the improvement has recently plateaued, the report said.

The report also cautioned that Europe's fiscal support may have a weaker impact on listed companies than expected because spending is concentrated in infrastructure, climate, energy transition and defence, sectors with relatively limited representation in public equity markets.

The report noted that the region's recent performance was supported by a cyclical manufacturing recovery and stronger earnings revisions, but the next phase will increasingly depend on whether European companies can convert AI adoption into measurable productivity and profitability improvements. (ANI)

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