LONDON (Reuters) -European stocks took an early lead in 2025, outperforming Wall Street thanks to erratic U.S. policymaking and Germany's once-in-a-generation fiscal shift, but U.S. markets have caught up. 

The broad European STOXX 600 index was up 6.6% so far this year, as of Friday's close, compared with 6.8% for the S&P 500. 

In March the STOXX was 10 percentage points ahead, leading European bulls to think this might be their time after years of European markets underperforming Wall Street. 

Calls for European outperformance still ring true in currencies, however, with the euro up 14% against the dollar year to date. 

Trade talks and the new U.S. tax-cut and spending law are tests for the rotation out of the U.S. and into Europe, said UBS Asset Management's head of global sovereign markets strategy Max Castelli. 

"I don't think U.S. exceptionalism will come back with the same strength and intensity," he said. "But I would not rule out the big period of outperformance of European assets over the U.S. being over." 

Here's a look at how Europe's performance against the U.S. stacks up.

BIG TECH IS BACK

Marija Veitmane, head of equity research at State Street Global Markets, said Wall Street shares started bouncing back in mid-April, partly because the "trade war became trade negotiations."

But the "real turning point" was corporate earnings season when "tech CEOs stood up and said 'Our earnings are going to be very strong'."

Tech accounts for roughly one-third of the S&P 500, and the sector is up 24% since the start of April, even including its plunge when U.S. President Donald Trump announced his tariff plans.

Nvidia, once again the world's largest company by market cap, has risen an even more dramatic 45%, and there isn't anything in Europe to match.

HOLD YOUR NERVE

But by no means all investors are rushing back to Wall Street with the S&P 500 at record highs, suggesting valuations are getting stretched.

"The tariff announcement showed how fast sentiment can change and how risky these high (U.S.) valuations are," said Madeleine Ronner, senior equity portfolio manager at asset manager DWS, adding that European valuations are more reasonable.

And while that gap had been appropriate because of slow corporate earnings growth, "Europe's (earnings per share) is starting to grow again, and the differential is getting smaller, which should be reflected in valuations," she said.

DWS sees U.S. and European GDP growth being roughly similar in 2025 and 2026, a further and sustainable boost to European companies' earnings.

CAN YOU BUY MORE DEFENCE STOCKS? 

Investors have snapped up European stocks, but that has centred largely on the same sectors -- defence, up 50% this year, and banks up 28%, suggesting a lack of faith in the broader market. 

The two account for more than 50% of the return of the STOXX 600, despite making up just 16% of the index, BNP Paribas Exane estimates. 

That's not surprising as NATO members have agreed to increase defence spending, and massively in the case of Germany. But valuations are stretched. 

Germany's Rheinmetall trades on a forward price to earnings ratio of more than 50; even Apple and Microsoft are only around 30. 

LOVING THE EURO 

The picture is clearer in currencies, where the euro is at a near four-year high and closing in on $1.20. 

At the start of the year many analysts predicted the euro would fall below one dollar, thanks to what was then seen as an insatiable demand for U.S. assets. 

But when this reversed, the euro began to appreciate, a move that grew as foreign holders of U.S. stock and bonds, fearing further dollar weakness, increased their currency hedges.

Now the euro is expected to keep gaining even if outflows from the U.S. stop. 

"Foreigners don't need to sell U.S. assets to weaken the dollar but merely to say 'No thank you' to buying more," Deutsche Bank's head of FX strategy George Saravelos said in a note.    

CURRENCIES MATTER

That currency move also affects equity investors, making European stocks cheaper for U.S. investors and Wall Street more expensive from Europe. 

The S&P 500 may be at a record high for domestic investors, but priced in euros it's 9% off its February top. 

"For euro-based investors the currency ate up so much U.S. assets' returns this year," said DWS' Ronner. "If there's another letdown, in euros that gets even worse." 

On the other hand, the STOXX 600 in local currency terms is still shy of March's record, but priced in dollars it hit an all-time high in late June.