Most importantly, we still believe that unlike the last 10 to 15 years, investors will see better risk-adjusted returns from being well regionally diversified than from running concentrated US portfolios.
The first half of 2025 has been quite the ride for equity investors. Volatility could well persist as the economic narrative continues to swing from recession to inflation fears, and the markets steer politicians towards sensible, amicable policy choices. Not getting top and tailed on newsflow, and being more regionally diversified than was optimal last cycle is the right strategy for ending the year on a high.
Following the strongest quarter since 2015 for European stocks relative to the US market1, global equities slumped at the start of April on the back of US tariff announcements. This negativity proved short lived, however, with the S&P 500 index only requiring 18 trading days to recover its early April losses. Provided that investors started the year with a well-diversified portfolio across regions and styles, doing nothing has likely been the optimal strategy.
Stepping back, three key market expectations have been put to the test thus far in 2025. The first was that technology company earnings would remain extremely strong, even with some moderation anticipated in consensus forecasts. Second was the assumption that earnings growth was set to broaden out beyond the megacap tech firms, to other sectors in the US market. The third assumption was that this broadening of earnings growth across sectors would support less tech-heavy regional equity markets.
Prior to April’s tariff announcements, these market narratives had already developed as new information came to light. Most importantly, ‘DeepSeek Monday’ in January had called into question the leadership of US tech giants in the AI race. The Chinese start-up DeepSeek claimed that it had managed to develop a large language model that would rival US equivalents with a fraction of the time and cost, which sparked a rotation away from the megacap US tech firms. And in addition to less exposure to the technology sector, which looked increasingly beneficial, Europe’s fiscal pivot added to the optimism towards the region.
US trade policy has tested market expectations further. After significant regional divergence in the first quarter of 2025, global equity markets have tracked each other more closely since 2 April, falling on trade escalation and rising when tensions have eased. The sector moves witnessed in April highlight where investors have looked for safety, with defensive industries such as staples and utilities outperforming more cyclical sectors such as energy and consumer discretionary over the month.
Importantly, corporate health remains a key support to the equity market. The slower economic growth that we anticipate ahead is not due to businesses having levered up too far and now needing to pull back. Instead, it reflects corporates battening down the hatches given elevated uncertainty, but from a position of relative balance sheet strength. This implies that earnings growth is likely to stall rather than slump, with a sharper decline likely requiring a more hostile policy stance to be sustained by the US administration.
The challenge for equity investors is that consensus earnings expectations are still more optimistic than the macro outlook implies, despite some moderation year to date. US earnings forecasts for 2025 have fallen by five percentage points since the start of January, but still sit at 9% year on year, with a further 14% growth anticipated in 2026. In Europe, 2025 earnings growth expectations began the year at a more moderate 8% year on year and have since come down significantly (see Exhibits 9 and 10).
The ability of corporates to pass higher input costs through to consumers is critical, but frustratingly difficult to forecast. In 2019, US margins did soften by approximately half a percentage point, although the magnitude of the trade shock was far smaller than today. This time, even if corporates do succeed in maintaining their pricing power, we anticipate that higher consumer prices would still result in weaker demand over time, which in turn would weigh on corporates’ earnings even if margins remain at robust levels. First quarter earnings season offered little insight into how corporates would handle higher input costs, with many companies either providing multiple sets of guidance based on different scenarios or preferring to pull their guidance altogether.
Uncertainty about future tax policy may have been another factor making corporates reluctant to offer firm guidance. When President Trump passed the Tax Cuts and Jobs Act in December 2017, a lower corporate tax rate triggered a 10-percentage point upgrade to earnings expectations in just three months. Yet while the exact shape of this year’s tax bill is still being refined, the 2025 tax cuts are set to be much more focused on consumers than corporates, which are therefore less likely to have a broad-based impact. Equity investors will also need to weigh the impact of new fiscal impetus against the impact on multiples of higher bond yields.
The earnings delivery of megacap tech is another vital part of the overall profits outlook (see Exhibit 11). One way to rationalise still lofty US earnings expectations despite building macro headwinds is to argue that the megacaps will be immune to cyclical weakness. It could yet be the case that CEOs see new artificial intelligence capabilities as so critical that tech capex remains rock solid, despite weaker growth. However, this feels a bold assumption to rely upon in such an uncertain macro environment, and one with no historical precedent (see Exhibit 12). Trade restrictions that limit the transfer of critical technologies around the world are another factor to consider when assessing the tech earnings outlook, beyond just the level of tariffs applied.
Valuations are a poor guide to future returns on any short-term horizon, but if earnings expectations are set to decline, we note that valuations across many markets remain elevated today. This suggests valuations have little room to absorb any earnings disappointment. In the US, this year’s derating has largely been a megacap story, with the valuation of the largest 10 stocks in the S&P 500 having fallen from 30x forward earnings entering the year to 27x at the end of May. In contrast, the valuation of the remaining 490 stocks is essentially unchanged, sitting at 20x forward earnings (see Exhibit 13).
Valuations outside of the US are certainly more reasonable when compared to the S&P 500 – but compared to their own history, they too now suggest a relatively high degree of optimism is baked in (see Exhibit 14). In Europe, equity valuations sit slightly above their long-run average levels, at 16x forward earnings, and are higher than at the start of 2025. Chinese valuations have also picked up relative to the start of the year, despite a still-sluggish growth outlook.
Given this highly uncertain backdrop, what should investors do? Most importantly, we still believe that unlike the last 10 to 15 years, investors will see better risk-adjusted returns from being well regionally diversified than from running concentrated US portfolios (as we laid out in our 2025 Outlook). The rotation from the US equity market to other developed markets has played out more quickly than we expected, but we still see room for this rotation to continue. This implies investors can benefit from rebalancing global equity portfolios that are still running significant US equity overweights.
At a regional level, our conviction in European markets, including the UK, remains stronger than our conviction in Japan. This reflects our view that a stronger yen is likely in multiple macro scenarios, which would weigh on repatriated overseas earnings and therefore pose headwinds for the relatively internationally oriented Japanese stock market. Simultaneously, many investors appear reluctant to embrace the positive growth impact that we expect from Europe’s fiscal pivot, as evidenced by the still large valuation discount on offer in many European sectors relative to their US counterparts (see Exhibit 15).
The outlook for emerging markets (EM) relative to developed markets appears less clear. As we lay out in Be mindful of currency exposure, a weaker US dollar should provide a tailwind to EM over the medium term, but a sluggish macro outlook in China tempers our optimism. Arguably the strongest rationale for EM allocations lies in the need to diversify global tech exposure, with further ‘DeepSeek Mondays’ impossible to rule out as tech innovation across Asia continues at a breakneck pace.
Income-oriented strategies are also likely to prove relatively defensive. In an earnings contraction, dividend growth typically pulls back by roughly half that of earnings, helping to buffer total returns from stock price drawdowns (see Exhibit 16). With payout ratios at low levels and corporates pulling back from capex, investors might expect even greater dividend resilience in a slowdown scenario today than has been typical historically.
Overall, the rollercoaster ride witnessed in global equity markets in the first five months of the year appears unlikely to reach a halt in the near term, not least because markets will continue to play a critical role guiding politicians towards more sensible, amicable outcomes. Robust corporate health provides something of a guardrail against large downside risks, but earnings expectations likely still need to moderate further given a slowing economic backdrop.
The top priority for investors must therefore be to ensure that their portfolios are sufficiently regionally diversified, with income-focused strategies acting as another tool to guard against further market ‘wobbles’.