European stock and bond markets are attracting a surge of global capital this year, defying earlier pessimistic forecasts that a war with Iran would plunge the region into stagflation. The Stoxx Europe 600 index has risen 11% year-to-date, while benchmark indices in Germany, Italy, and France have all hit record highs. German bonds are outperforming their U.S. counterparts, and the euro is trading near a two-month peak.

Investors are piling into European equities and fixed income, buoyed by the best quarterly corporate earnings in four years and steadily improving economic momentum. Growth is accelerating, but at a pace that does not alarm European Central Bank policymakers. Some bond funds, in particular, view Europe as a more attractive destination compared to the U.S., especially given the lack of clarity surrounding the Federal Reserve's policy outlook.

"The economy is in a sweet spot, where the ECB doesn't need to hike because inflation isn't out of control, and growth is strong enough to support equity markets," said Sophie Huynh, a portfolio manager at BNP Paribas Asset Management. "We have increased our bullish positions on European stocks, as there is still room for further upside."

According to industry research data, second-quarter profits for MSCI Europe index constituents rose 17% year-on-year, the largest increase since late 2022. Cyclical sectors like mining and industrial goods were among the key contributors to this growth. "Investors are genuinely attracted by the resilience of corporate earnings," said Helen Jewell, Chief Investment Officer for Fundamental Equities International at BlackRock. She noted that Europe's broad exposure to the artificial intelligence supply chain allows investors "to participate in the AI theme in a more diversified and lower-risk way than in the U.S. or parts of Asia."

As Europe's economic outlook improves, albeit while still lagging other major economies, bond investors are also turning their attention to the region. Compiled data shows that eurozone real GDP is expected to grow by 0.8% in 2026 and 1.2% in 2027, below the U.S. projections of 2.2% and 2.1% for the same periods. The ECB has already raised its key interest rate by 25 basis points once this year in response to war-induced inflation, with two more hikes expected by mid-next year. However, the relatively modest growth outlook helps sustain demand for eurozone bonds, particularly as fiscal and policy risks in markets like the U.S. and Japan become increasingly difficult to price.

"European government bonds remain attractive to international investors," said Erik Liem, a rate strategist at Commerzbank. "The ECB has already reacted to the Iran shock, and its policy path is easier for the market to predict compared to the Fed, whose communication direction is shifting." Last week, the yield spread between 30-year U.S. Treasuries and German Bunds widened to its highest level in a year, as investors began questioning the Fed's credibility and the long-term U.S. fiscal outlook. Europe also faces fiscal pressures, with elections upcoming in France and Italy next year, but the market currently views these risks as relatively manageable.

The improved demand for European assets is also reflected in the euro's strength. The currency hit a seven-week high on Friday and is now trading above $1.15. While this is partly due to a weaker U.S. dollar, Mitsubishi UFJ Financial Group expects the euro to climb to $1.20 by mid-next year, as global reserve managers further diversify their currency holdings. "The currency to increase exposure to most over the next 12 to 24 months is the euro," said Derek Halpenny, Head of Research at MUFG Bank.

Nevertheless, some market participants remain skeptical about how long Europe's renewed appeal will last. Duncan Toms, a multi-asset strategist at HSBC Holdings, believes that whether Europe can continue to outperform depends on the speed at which investors rotate back into the stocks that previously led the AI rally, particularly the semiconductor sector. "We think the recent adjustment in momentum is largely over. From a relative performance perspective, if the semiconductor sector regains strength, the difficulty for Europe to sustain its outperformance will increase significantly," Toms said.