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Equity outlook: The high cost of global fragmentation for US portfolios
Quarterly Outlook 5 minutes to read
Key points:
- US exceptionalism: fading or just pausing? The easy bet on US and Mag 7 outperformance is over. Policy uncertainty, AI risks, and a potential recession are reshaping the investment landscape.
- More pain likely ahead: Mega-cap tech faces headwinds, and US portfolios are overexposed. Tariffs, fiscal tightening, and slowing AI momentum could shake up market dynamics. Investors can hedge volatility with US defensives or seek global alternatives.
- Opportunities in a shifting global landscape: European equities are benefiting from fiscal expansion, China’s policy support is lifting tech and consumer stocks, and emerging markets stand to gain from a weaker USD, provided US recession fears remain contained.
US exceptionalism: a peak or just a pause?
The straightforward trade of betting on US outperformance has become far more complicated, as investors reassess expectations of high growth, tax cuts, deregulation, and AI-driven expansion that fuelled optimism earlier this year. Adding to this market volatility is the uncertainty around Trump’s policies and disruptive developments like China’s DeepSeek.
The biggest concern? A potential US recession. While real data has yet to confirm a slowdown, recent business and consumer surveys indicate economic softness. A globally diverging fiscal landscape is further reshaping equity markets. The US is moving toward budgetary tightening, while Europe and China embrace stimulus. Historically, reduced government spending has weighed on corporate earnings. Meanwhile, tariffs are reintroducing volatility, complicating business planning.
It could get worse before it gets better
Despite economic softness and fiscal tightening, US equities outside the ‘Magnificent 7’ remain resilient, with defensive sectors like health care, consumer staples, and energy posting YTD gains. However, mega-cap tech stocks could face further downside, as AI monetisation, capex uncertainties, tariff risks, and Chips Act funding pose headwinds. Investors with broad US or MSCI World exposure may find themselves overallocated to US tech due to years of asymmetric gains, increasing portfolio risk.
The AI theme is broadening, with the next wave likely benefiting AI enablers—companies providing critical infrastructure and software—rather than just early movers. Beyond tech, if growth deteriorates or tariff concerns escalate, industrials, consumer discretionary, and financials could come under pressure.
Investment playbook: two paths forward
Given this backdrop, investors have two primary tactical strategies for Q2: hedge for volatility and rotate into US defensives or diversify internationally and capture brewing opportunities.
1. Managing risk: hedging and defensive positioning in a volatile market
Trade disruptions pose risks to technology, communications, and materials, while industrials are caught between re-industrialisation tailwinds and potential tariff headwinds. Meanwhile, sectors like consumer discretionary and financials are more vulnerable to an economic downturn due to weakening consumer demand and credit risks. While long-term themes like AI and automation remain intact, near-term headwinds make tactical hedging essential.
For those staying in US markets, defensive sectors offer relative safety. Health care has structural tailwinds from an ageing population, though policy risks remain. Consumer staples, a traditional safe-haven sector, faces headwinds from negative Q1 earnings expectations and an elevated forward P/E multiple. Utilities usually perform well with lower bond yields and may need additional Fed rate cuts to sustain gains. So, a clear case for defensive positioning remains difficult to make, reinforcing the importance of quality. Companies with strong balance sheets, consistent cash flows, and pricing power are better positioned to weather economic headwinds. A low volatility, high dividend strategy could also be attractive in an uncertain environment. Companies with stable earnings, strong dividend payouts, and low correlation to market swings can offer downside protection and yield.
For investors looking ahead to potential pro-growth Trump policies, small-cap stocks with strong domestic demand could provide upside, particularly in infrastructure and automation-related industries. Financials and energy are also likely to benefit from deregulation, with financials currently trading below their average one-year forward earnings. However, policy implementation remains uncertain, reinforcing the need for hedging strategies.
2. Seeking opportunity: global alternatives to US dominance
With the US facing fiscal tightening, global equities present compelling alternatives:
Europe: After years of underperformance, European stocks are showing signs of strength, benefiting from fiscal expansion and monetary easing that are creating a more supportive economic backdrop. Germany’s DAX index has surged 13% YTD, while the broader EU STOXX 50 is up 9%, outpacing US equities. With the EU and NATO strengthening their defence commitments, total spending could rise from roughly 2% of GDP to 3.5% in the coming years and is likely to benefit the aerospace and defence industries. In fact, Germany’s shift away from fiscal austerity is going beyond defence to boost infrastructure and energy, and could be favourable for mid-cap stocks (MDAX), which have more domestic exposure and are well-positioned to gain from increased public investment.
Valuations still remain attractive, with European equities trading at a significant discount to US stocks, and hopes for a resolution to the Ukraine war could further boost sentiment by bringing back cheaper energy. Massive reconstruction efforts in Ukraine could also drive long-term growth, with the World Bank estimating up to USD 486 billion in engineering and construction projects over the next decade. Even if actual spending falls short of this projection, it would still provide a major boost to infrastructure and industrial sectors.
However, risks remain. Rising bond yields, particularly in Germany, could pressure borrowing costs and weigh on market sentiment. Geopolitical uncertainty could linger even after the potential Ukraine resolution, dampening investor confidence. Any signs of slowing execution risks with fiscal stimulus could also challenge the current rally. Additionally, trade threats remain hard to ignore, with potential US tariffs on European goods posing a risk to export-driven sectors, particularly autos and industrials.
Sceptics argue that the recent outperformance may be more of a short-term value rotation than the beginning of a structural bull market. Yet, with strong fundamental drivers in play, Europe’s resurgence is one to watch.
China: After a prolonged slump, Chinese equities—particularly tech and consumer stocks—are starting to attract renewed interest, driven by cheap valuations, government stimulus, and excitement around AI innovation. The Chinese government’s fiscal deficit ratio is at its highest level in over 30 years, and a CNY 4.4 trillion local government bond issuance underscores Beijing’s commitment to economic recovery.
Chinese tech stocks, once battered by regulatory crackdowns, are now benefiting from a more stable policy environment and a surge in AI developments, particularly around DeepSeek. AI, semiconductors, and e-commerce giants are seeing stronger growth prospects, while lower valuations offer an attractive entry point compared to their US counterparts. Meanwhile, consumer spending is showing signs of resilience supported by targeted government incentives.
As with Europe, risks still remain. The AI rally could prove fleeting if investor enthusiasm fades, and structural challenges persist in China’s policy execution and regulatory landscape. The property market remains fragile, and geopolitical tensions could still dampen foreign investment appetite. While uncertainties linger, selective opportunities in Chinese tech and consumer sectors offer an intriguing risk-reward setup, especially as Beijing continues to prioritise economic stabilisation and tech innovation.
Japan and emerging markets: Japan’s corporate governance reform and earnings momentum also remain key themes, but the broader market faces risks from the appreciation of the Japanese yen, and selectivity will be key. Ongoing rate hikes and steady economic momentum favour Japan’s banking sector. Meanwhile, a weaker US dollar could boost emerging markets, provided the threat of a US recession remains measured.
Risks to the rotation trade
The biggest risk to this rotation remains the durability of the divergence between US and international stock markets. A broader pickup—in European markets beyond defence and in China beyond tech—is needed to sustain the trade.
The S&P 500 still boasts the highest quality among global indices, with superior earnings growth potential. If US valuations moderate but earnings resilience persists, global diversification may face headwinds. Tariffs, if implemented aggressively, could also disrupt international markets, making the rotation into non-US assets more volatile than anticipated.
Finally, if tax cuts and deregulation gain traction in US policy focus, capital flows could pivot back to US equities, shifting the narrative away from tariffs and towards domestic economic stimulus.