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After a nearly two-year lull, volatility surged in equity and bond markets at levels experienced only a few times in history! President Trump’s tariffs and trade war have thrown markets an extreme curveball, making it extremely difficult to determine how things will play out. This level of uncertainty often leads to fear and panic, which then leads to irrational decision-making. To help put things in perspective, the S&P 500 has already experienced four 5% pullbacks this year compared with a combined total of five in 2023 and 2024.
Unfortunately, there is no magic formula or simple way out of this. As we always preach, diversification is your best friend during these times. While it won’t eliminate volatility or prevent you from losing in a down market, it provides the necessary ingredients to help keep you invested so you experience the good times.
There have been a few positives amongst all this volatility. Most of the attention has been on the bond market, which has been extremely resilient minus a brief stretch of a few days. While high-quality bonds are positive on the year, a certain equity market is gaining attention and leading some to ask if we are finally witnessing a changing of the guard. This change refers to non-U.S. equities, specifically Europe, and its recent outperformance of the U.S. (S&P 500).
As seen in the chart below, it’s been a long time since the S&P 500 has lagged its foreign market counterparts in Europe (EAFE) and emerging markets (EM). While we have experienced brief moments, what we’ve seen this year has been impressive, considering the degree of outperformance and the fact that it’s gone on the entire year.
It is important not to be a prisoner of the moment. Good or bad, a few months should be taken for just that. Overinterpreting a small sample size can cause undue stress and tempt you to make irrational portfolio decisions.
As of this writing, the European Index is outperforming the S&P 500 by ~17% year to date. Emerging markets are also outperforming, but to a lesser degree. While these differences are staggering, the bigger picture tells the full story. Even with this recent underperformance, the S&P 500 is still outperforming the European index by ~140% and the emerging markets index by ~180% over the past 10 years. That outperformance is an eye-popping ~400% and ~390% over the past 20 (chart below).
Much of this can be chalked up to the resiliency of the U.S. consumer, an extremely accommodative Federal Reserve, the emergence of the MAG7, and the U.S. being the most stable economy going into and coming out of COVID. These factors helped propel the S&P 500 year after year, and the thought of owning anything else became somewhat of an afterthought, especially leading into this year.
So the question is: What’s causing this shift, and is it likely to continue?
The year started with plenty of skepticism about Europe’s economy, given President Trump’s trade policies and tariff talks, the uncertainty in the ongoing Russia-Ukraine conflict, and an already somewhat fragile economic backdrop. Then markets did what they usually do: surprise everyone by doing the opposite of what was expected.
Much of this recent surge in European equities comes on the heels of a commitment from many countries to significantly boost their infrastructure and defense budgets. This is a change as Europe has historically been reluctant to spend to stimulate growth.
If there isn’t peace in Ukraine, European economies will spend more on defense. Likewise, if there is peace, they will spend on defense to ensure peace remains. Either way, spending seems like a requirement, given President Trump’s wake-up call to Europe to reduce its military reliance on the U.S. moving forward. In addition, earnings have held up reasonably well, and most of Europe has not been hit with the same level of tariffs as the rest of the globe. These all play a role in explaining the gap we’ve witnessed this year.
With all the uncertainty from this administration’s trade policy, European stocks have become somewhat of a safe haven and are viewed as a diversifier away from the “Trump Risk.” Now, it needs to be stated that the outperformance has largely come on the backs of a few sectors, mainly defense. Sectors such as healthcare, automakers, and consumer discretionary continue to underperform the wider market. For this trend to continue, these other sectors will need to participate to carry the momentum further.
This somewhat reminds me of the tech sector in the U.S., which helped propel markets higher and is now starting to crack, as many tech stocks are down 20% to 40% this year!
Even with this recent gap in performance, U.S. stocks continue to trade at a 50% price-to-earnings (P/E) premium to European stocks. U.S. growth is projected to exceed Europe’s, but if this gap narrows, we could see the momentum continue.
So what is an investor to do? Well, for starters, if you are not properly diversified, now is the time to address it. For those who are, whether you should increase your exposure to non-U.S. equities depends on several factors. This is something we analyze for clients to determine if we feel an overweight is warranted. Of course, the landscape can change quickly, and a portfolio needs to be able to adapt, but you want to be careful about chasing returns, as tempting as it can be.
I know it’s hard to think in the long term with so much uncertainty and volatility on a daily basis, but that is what needs to be done. Making large-scale investment changes based on short-term price movements is not advisable.
Feel free to discuss your situation with our financial planning firm.
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