Europe's stock market rally has become increasingly concentrated this year, amplifying risks as investor optimism wanes. An underperformance against US stocks has deepened over the past month despite stronger European economic surprises. While oil prices above $100 increase the likelihood of interest-rate hikes globally, pricey crude poses a bigger problem for import-dependent Europe.

Crowding in a small number of high-performing themes has encouraged investors to broaden exposure. Bank of America Corp. strategists, including Paulina Strzelinska, noted a "softer bull case" for Europe in the firm's fund manager survey published Tuesday. Global investors are now net 5% underweight euro-zone equities, flipping from net 6% overweight just a month ago.

By contrast, they are net 25% overweight US equities, not far off the 27% in the previous poll. Moreover, a net 8% expect to underweight Europe over the next year. For the majority of survey respondents, declining energy prices and easing inflation remain the key potential positives, while 43% view disappointments in AI investment as the largest downside risk.

No fund managers cited spending on AI, digital, or data centers as a driver of European growth. Instead, they have pursued economy-linked sectors like basic resources, technology, and industrials to capture the benefit of low interest rates and fiscal stimulus. Exposure to banks remains elevated but has dropped by half since last month.

This pattern is backed by data such as the euro-zone PMI manufacturing survey, which supports the case for cyclicals. The gauge has improved sharply over the past three years and has been in expansion territory since February. European industrials geared to electrification and data centers have been in favor, benefiting from rising capex and low financing costs.

Meanwhile, the European Central Bank has turned more hawkish as elevated oil prices stoke inflation worries. The central bank raised rates this month, and the swap market expects three more hikes through April. With investor exposure to defensive sectors relatively low, diversification could be ahead for Europe given the potential hit to economic growth.

CIC CIB strategists Nicolas Bouthors and Maxime Garcia warned that the geopolitical context is becoming an increasingly tangible obstacle, with rising energy prices problematic for growth and inflation. Strategists expect 2027 profit forecasts to be cut by at least 5%, favoring sectors exposed to interest-rate volatility, such as banks and insurance, and strong growth thematics like defense and electricals. Globally, they prefer US stocks, where exposure to the AI theme is higher.

Earnings growth in Europe is still running strong but trails the US. Stoxx 600 profits are expected to surge 15% this year and 9.7% in 2027, compared with jumps of 27% and 19% across the Atlantic. As a result, the European market has been losing its valuation discount cushion quickly, now trading near its long-term average discount to the US market of about 20%.