Importantly, regional diversification does not just mitigate risk; it can also be return enhancing.
With policymakers globally adding fuel to the economic engine, we are positive about a broadening of global growth. This economic outlook should support equity markets outside the US. Investors should therefore ensure their portfolios are not overly concentrated in US tech (see Navigate tech concentration carefully), even if the US rally could successfully extend into 2026.
Importantly, regional diversification does not just mitigate risk; it can also be return enhancing. Of course, diversification will help hedge portfolios against the risk of a retrenchment in sentiment towards artificial intelligence (AI) and subsequent market correction. But diversification can also boost returns in a world where the AI rally continues, as we’ve seen in 2025 (see Exhibit 17).
In 2026, the focus should be on markets with improving fundamentals, and to some degree those less correlated with AI sentiment. Returns will likely be increasingly driven by earnings rather than by multiple expansion, given equity valuations are elevated in many regions (see Exhibit 18). Investors must also weigh the impact that currency moves might have on returns.
European equities: Earnings improvement
European equities had a strong start to 2025, fuelled by a large valuation gap with the US, under-positioning in Europe, and a sharp shift in Germany’s fiscal policy. But disappointing earnings have caused performance to stall since June.
After seven months of negative revisions to earnings per share (EPS) forecasts, Europe’s 2026 EPS estimate is now being revised up and bottom-up forecasts point to growth of 12% year on year. Mid-single digit growth seems more realistic to us, consistent with the typical pace of downgrades to consensus EPS expectations.
The first driver of positive profit growth is a likely slowing or stalling of euro appreciation in 2026, which should offer relief to European companies given they generate about half their revenues internationally. The euro has appreciated meaningfully versus the US dollar in 2025, driven more by dollar weakness than by stronger European growth prospects. This has contributed to the 17% downward revision in 2025 EPS estimates for European exporting sectors, versus a 1% upward revision for domestic sectors (see Exhibit 19).
Second, more stable energy prices should also support European profits, given the weight of commodity-related sectors in index earnings. European commodity sectors have seen their 2025 EPS estimates revised down 27% this year as oil prices have fallen. In 2026, EPS growth for the energy and materials sectors is forecast to rebound to 7% and 31% respectively, and revisions have recently turned positive.
It is not just the removal of headwinds that should return European earnings to growth. The European economy could also surprise to the upside. Eurozone GDP growth expectations are already on an upward trajectory, and fiscal policy should provide a further boost, especially in Germany where we expect growth to pick up from zero to well above potential (see Monetary and fiscal fuel is powering expansion).
Still ‘less expensive’, if not outright cheap
European valuations remain attractive relative to US equities and other assets. The MSCI Europe ex-UK Index is the only major equity index with a 12-month forward P/E ratio currently below its start-2022 level (see Exhibit 20). European multiples are currently 35% lower than in the US, close to all-time wides. Yet the earnings growth gap between the two regions is narrowing. After the global financial crisis, US earnings have grown on average 8 percentage points faster than European earnings (annualised), but this gap is expected to shrink to 2 percentage points from 2025 to 2027. Thus, on current consensus forecasts, investors can pay a multiple of 16x forward earnings in Europe (ex-UK), or 23x in the US, for relatively similar future earnings streams.
Stay selective
While we are broadly positive on Europe, we nonetheless recommend investors are selective, focusing on three main areas: banks, fiscal beneficiaries, and the GRANOLAS.2
First, European banks are attractive. Despite returning nearly 200% including dividends since the start of 2022, we believe the sector still has tailwinds. European banks trade at a reasonable price-to-book ratio of 1.1x, well below their pre-global financial crisis average, and offer a robust shareholder yield (buybacks plus dividends) of 8%. Profit growth has been more than double that of the broad index since 2019, and revisions to consensus 2026 EPS forecasts show continued strength. Stronger nominal growth and steeper yield curves than in the 2010s should further support bank earnings.
Second, fiscal beneficiaries look set to do well. The European Union plans to release significant funds over the coming years for defence, power security and infrastructure. Companies in these sectors have surged: a basket of European defence names is up over 100% year to date, and capital goods firms involved in AI infrastructure and utilities have also gained strongly. We believe this rally has further to run, as in our view investors are still sceptical about the delivery of European spending. Europe’s defence firms are expected to grow their earnings much faster than their US peers over the next few years. When compared to the growth in military spending, recent valuation expansion appears more reasonable.
Third, the GRANOLAS are attractive laggards. These firms, which represent Europe’s 11 largest stocks across the healthcare, staples, tech and luxury sectors, have underperformed since early 2022 as yields rose sharply, the euro strengthened, and growth in China slowed. Now on a 19x forward P/E ratio, the GRANOLAS trade at a discount to the S&P 500 and at a smaller premium to the rest of Europe than in recent years. They offer a hedge against shifts in AI sentiment, as their correlation with the Magnificent Seven is low. Some sector-specific factors may also improve. European luxury companies, which have underperformed by c.25% since the start of 2023, could benefit from a pickup in Chinese demand as an equity rally and housing market recovery help stabilise household wealth.
China: The AI investment case at a more reasonable price
We are modestly positive on China. While the Chinese market has rallied nearly 80% since its low in early 2024, we believe that the bull market can continue, albeit at a more moderate pace, driven by both earnings and valuations.
Focus on tech and exporters
The fundamental backdrop is improving for Chinese equities, powered by the tech sector. Consensus forecasts expect MSCI China EPS growth to pick up from 2% in 2025 to 15% in 2026, and maintain this strength in 2027, well above last decade’s average of 10%. Technology firms are key drivers of this profit growth: consensus 2026 EPS forecasts for China’s tech sector have been revised up 4% this year, and annualised earnings growth over the next two years is expected to be over 30%. Chinese tech stocks trade on lower multiples than their US counterparts (25x vs. 31x forward earnings) yet are expected to deliver stronger earnings growth.
Chinese tech firms are also well positioned to take advantage of future AI development. In a recent survey, 93% of Chinese participants reported using AI intentionally at work in 2024, compared to 67% in the US.3 Data centre capacity is expected to grow faster in China than in the US over the next few years (see Exhibit 21). We suspect there will be fewer regulatory frictions slowing broad AI integration in China than in other countries, which may take a more considered but therefore slower approach.
Chinese tech firms also benefit from state support, with the government’s latest five-year plan highlighting technology as an area of focus. State support has previously helped Chinese industries such as electric vehicles (EVs) develop astonishing economies of scale which international competitors have been unable to match. Chinese EVs now make up nearly two-thirds of global sales (see Exhibit 22), and China’s share of European EV sales sits six times higher than in 2020.
Beyond tech, we are positive on Chinese exporters more broadly. The Chinese government continues to provide stimulus to its favoured industries, many of which are export-oriented such as solar module manufacturing. Efforts to reduce excessive competition (‘anti-involution’) may lead to consolidation in high-competition sectors such as EVs, supporting larger companies’ net income margins.
Chinese exporters have also demonstrated their ability to reroute their goods despite global trade headwinds. China’s exports have grown strongly in 2025, with losses in the US more than offset by gains elsewhere, particularly to emerging markets (see Exhibit 5 in Monetary and fiscal fuel is powering expansion). China also holds a dominant position in global supply chains for rare earth metals, solar modules, lithium batteries and EVs. Thus, export sectors are expected to drive MSCI China’s profit growth in 2026, with consensus EPS growth for the technology and autos sectors sitting at near 40% and over 80% respectively.
Two key risks to our view on Chinese equities are AI sentiment and Chinese regulation. If sentiment towards AI weakens, Chinese tech firms could suffer due to their correlation with US tech stocks. And any regulatory shift from Chinese policymakers, similar to late 2021, could derail the China rally, though this is not our base case.
Other emerging markets: Export rerouting a headwind
Chinese resilience could come at the expense of other emerging markets (EM): a sustained rise in Chinese exports to other nations would weigh on EM ex-China profits. To become more positive, we would need to see stronger earnings growth in the financial and commodities sectors. However, with EM central banks generally easing policy rates, banks are unlikely to drive profits, and commodity prices are expected to remain stable but low.
One exception to this view is North Asia – South Korea, Taiwan and Hong Kong. These markets tend to perform well when the Federal Reserve is cutting rates, due to their cyclical nature and concentration in long-duration sectors, such as technology, capital goods and healthcare.
Japan equities: Ride reflation, be aware of currency risk
We also see opportunities in Japanese equities. An improving domestic political environment, continued corporate reform, strong earnings momentum (see Exhibit 23), and room for valuation expansion should support the Japanese market. However, investors should remain alert to how yen moves could affect returns.
Policy and fundamentals supportive
The election of Sanae Takaichi as prime minister on 21 October extends the relatively supportive political backdrop in Japan. The new prime minister’s pro-growth stance, plus her focus on US-Japan cooperation and national security, was taken positively by markets. Since her election, expectations of hikes from the Bank of Japan (BoJ) have been pushed out.
As in Europe, in our view Japanese equity valuations still have room to expand. While current valuations may seem high compared to the past 20 years, this period includes the aftermath of the asset price bubble, which depressed multiples. Looking at a broader timeframe, the TOPIX’s forward P/E ratio of 15.8x is well below its average since 1990 (24x), and still below its Abenomics peak of 16.3x. Rising bond yields are also benefiting earnings in the financial sector, which makes up about 15% of the TOPIX.
Favour defence and banks, watch the yen
Within Japanese equities, we favour defence-related stocks, which are set to benefit from increased global military spending and the new prime minister’s hawkish foreign policy stance. Japanese defence-related stocks trade on 20x 12-month forward earnings, compared to 22x for a US defence basket.
We also see strong potential for Japanese banks. Japanese banks have outperformed the TOPIX since 2021, aided by reflation, but still trade at a price-to-book ratio of just 1x. Although Takaichi is encouraging the BoJ to keep interest rates low, the bank’s next move is still likely a hike, which would support financial sector margins. Earnings revisions for Japanese financials have been very positive, surpassing those of their US peers.
The key risk for Japanese equities remains the yen. Given 40% of TOPIX revenues come from overseas, Japanese equity performance is typically negatively correlated with the yen (see Exhibit 24). For European investors, what is lost via yen moves is often gained on the equity market, and vice versa.
Conclusion
We believe diversifying equity portfolios regionally can both enhance returns and protect against concentration risks, particularly if AI sentiment turns less positive. Outside the US, we see the strongest opportunities in select areas of the European, Japanese and Chinese markets with fundamental tailwinds, including European and Japanese banks, Chinese tech and exporters, defence names, and fiscal beneficiaries.