Recent trends in the UK and European stock markets suggest a potential shift in favor of growth stocks, as value stocks have enjoyed a major upward trajectory in recent years. Value stocks, typically characterized by lower valuations in comparison to their earnings, have significantly outperformed their growth counterparts. The MSCI Europe Value Index has shown an impressive advantage of 17 percentage points over the MSCI Europe Growth Index in 2025, and a steady annual outperformance of 5.2 percentage points over three years. Similarly, in the UK, value stocks have outpaced growth stocks by 11 percentage points in 2025, with an annual edge of 3.2 percentage points.
However, some analysts express concern that this trend may be reaching its peak in 2026. A crucial factor influencing market returns is the relationship between bond yields and corporate earnings, particularly in the short term. A common misconception among investors is to heavily base stock market expectations on projected earnings growth and company valuations, particularly as the new year unfolds. Yet, empirical evidence suggests that a mere 1 percentage point change in government bond yields can prompt a nearly 10 percent swing in stock market valuations, whereas a 10 percentage point increase in anticipated earnings growth might only result in a 1 to 3 percent market adjustment.
This phenomenon stems from the fundamental principles of company valuations, where the fair value of a business is determined by the net present value of its anticipated profits, discounted back to their present value. The discount rate is predominantly influenced by long-term government bond yields, coupled with a risk premium that varies from company to company. When a company’s profit outlook improves, the actual impact on stock prices is fleeting. In contrast, fluctuations in government bond yields have a persistent and amplified effect on stock valuations because they alter the discount rate applied to future profits.
A stark illustration of this was seen in 2023. Following significant inflation and Central Bank rate hikes in 2022, market strategists anticipated that the UK and European economies would face renewed recessions, leading to diminished earnings growth and potentially negative market returns. However, as inflation pressures began to abate and bond yields fell, many investors recognized that these favorable conditions would bolster market valuations, counteracting declines in earnings. By the close of 2023, the Stoxx Europe index had realized a total return of 16.6 percent, with the FTSE 350 up 7.7 percent, highlighting the resilience of markets in the face of downturn projections.
Looking forward to 2026, there is speculation about the continuation of declining government bond yields, particularly in the UK, where inflation is anticipated to fall and the Bank of England may further cut interest rates. Such developments could bring 10-year gilt yields down from 4.5 percent to approximately 4 percent by the end of 2026, potentially boosting UK stock market returns by around 5 percent in the upcoming year. However, not all stocks will benefit equally. Growth stocks tend to have higher proportions of their profits projected further into the future, making them more sensitive to changes in discount rates. Conversely, the slower growth characteristic of value stocks means they are less impacted by such shifts.
If gilt yields decrease as projected, growth stocks may outperform value stocks by a margin of around 5 percentage points within the next twelve months. This trend may also extend across Europe, though the degree of yield decline could vary, especially in Germany, where increased fiscal spending may curtail the drop in bond yields.
In summary, while value stocks have garnered impressive returns in recent years, shifting macroeconomic factors and changing bond yields may herald a new phase where growth stocks regain favor. Investors are advised to be cognizant of these dynamics as they plot their strategies for 2026 and beyond.
