Despite very significant shifts in U.S. economic policy and major geopolitical events, investors can look back at the first half of 2025 with some satisfaction. Through July 3^rd, the S&P500 provided a total return of 7.5% for the year, despite being on the brink of a bear market just three months ago. Fixed income has also done well, with 10-year Treasury yields falling by 23 basis points, generating a 4.2% return year-to-date while high-yield bonds have delivered 4.8% on the back of a further narrowing of already tight spreads.

However, the standout performance has come from non-U.S. equities, with the MSCI ACWI ex-U.S. generating a total U.S. dollar return of 19.0%, comprised of a 9.7% local return and an 8.4% currency gain, reflecting a dollar decline.

Even with this, most investors are heavily underweight non-U.S. stocks. For the second half of 2025 and beyond, a key question is whether the dollar decline will continue, amplifying the return on international assets. This, in turn, depends on prospects for growth, inflation and interest rates, both in the U.S. and abroad, and whether, more broadly, investors continue to believe that U.S. assets justify a valuation premium that has been growing for the best part of 20 years.

U.S. Growth, Inflation and Interest Rates

On U.S. growth, the passage of OBBBA has brought clarity to fiscal policy. Over the weekend, the Administration appeared to delay the deadline for deals to avoid “reciprocal tariffs” from July 9^th to August 1^st. Even with this, however, trade policy is gradually becoming clearer. Moreover, data are beginning to paint a clearer picture of net immigration and labor supply as illegal immigration has slowed to a trickle, the Administration ramps up deportations, and traditional immigration has begun to fall sharply.

While policy confusion is diminishing, and notwithstanding some potential gains from deregulation, it appears that the aggregate impact of these policies should be dollar negative. In particular:

• First, assuming that the most recent round of temporary tax cuts become permanent, even with substantial tariff revenue we estimate that the federal government will run a deficit of over 6% of GDP in both fiscal 2026 and fiscal 2027 and that the debt to GDP ratio will surge from 97.8% in fiscal 2024 to 122.7% in fiscal 2034.
• Second, the drag from tariffs on the consumer sector will likely exceed the stimulus from tax cuts most of the time over the next few years, with the exception of the first half of 2026, which should see a bumper crop of income tax refunds.
• Third, dramatic shifts in immigration policy could cut net immigration to well below 500,000 per year, (compared to an annual average of over 1,000,000 since the start of the century), a trend which, in combination with the continuing retirement of the Baby Boom, should lead to a steady decline in the working-age population.
• Finally, higher tariffs will feed through to higher consumer inflation by late 2025 and this inflation could be sustained into early 2026 by the stimulative effects of surging income tax refunds and a lack of labor supply. This, in turn, should imply less monetary easing, with the Fed potentially still delivering just one cut this year in December.

Some of these effects could be mitigated by less regulation, corporate tax breaks, the impact of recent stock market gains on consumer wealth and productivity gains from AI. However, as a broad statement, the economic outlook is for somewhat slower growth, somewhat higher inflation and interest rates and somewhat faster-rising federal debt than might have been anticipated a year ago.

For the dollar, capital flows into U.S. assets have been an important source of strength in the past. While higher U.S. interest rates would generally be a positive for fixed income flows, this should be negated by higher inflation and concerns around rising federal debt. Meanwhile, slower economic growth should hurt earnings and thus diminish the attractiveness of U.S. stocks. Moreover, despite tariffs, the United States is very likely to run a considerable trade deficit for years into the future, exerting some downward pressure on the exchange rate.

International Growth, Inflation and Rates

However, there are always two sides to an exchange rate and problems overseas could, at a minimum, continue to slow the dollar slide.

• The Eurozone economy is still exhibiting sluggish growth with real GDP in Germany, France and Italy all growing by less than 1% over the past year. While the unemployment rate, at 6.3%, remains low relative to history and inflation, at 1.9% year-over-year, has returned to manageable levels, economic growth has been very sluggish in recent years and is threatened by the impact of U.S. tariffs. However, both fiscal stimulus, broadly, and increased defense spending, specifically, could bolster economic growth more generally even as inflation pressures ease. While Eurozone short rates, at 2.0% on the deposit rate are significantly below U.S. levels, they are unlikely to fall any faster from here than in the U.S. while Europe’s significant trade surplus with the United States could continue to boost the euro relative to the dollar.
• The U.K. is continuing to struggle with the long-term impacts of Brexit, mounting government debt and a nervous U.K. bond market. That being said, Britain has sidestepped the worst of the trade war, signing a trade agreement with the U.S. in May that generally inflicts lower tariff rates on Britain than on other U.S. trading partners. This, combined with solid economic growth at the start of the year and very cheap equity valuations could continue to boost sterling relative to the dollar going forward.
• China, by contrast, is being hit more significantly by U.S. tariffs, both directly and through higher tariffs on transshipments, that is goods that are sent from China to the U.S. via a third country such as Vietnam. While China and the United States have agreed to a trade truce, tariffs on Chinese goods exports to the United States remain 30 percentage points higher than at the start of the year. China’s problems with oversupply in the housing market and heavy government debt are being made worse by a falling population while inflation has fallen close to zero and policy rates remain at very low levels. While most of this would seem to support a decline in the Yuan relative to the U.S. dollar, China has also been trying to increase the international use of the Yuan and would likely favor a relatively stable Yuan-USD exchange rate going forward.
• Japan should have experienced positive economic growth in the second quarter following a mild contraction in the first. Business sentiment remains strong and, while consumer inflation has stabilized in recent months following a steady increase, wages are continuing to rise, reflecting a tight labor market. Japan is very vulnerable to higher U.S. tariffs, particularly on its auto exports. If Japan can negotiate a less damaging trade deal with the U.S., then the BOJ should continue to normalize rates from low levels, potentially boosting the Yen-U.S. dollar exchange rate.
• Finally, Canada and Mexico are both suffering from the impact of higher tariffs and trade uncertainty with the U.S. and both countries could end up in recession this year. Despite this both the Canadian dollar and the Mexican Peso have appreciated against the greenback this year and could rise further when the Federal Reserve resumes its easing.

Putting it all together, the global economy isn’t exactly booming in the middle of 2025 with U.S. trade policy having a negative impact globally. However, in contrast to previous trade wars, geopolitical shocks and other global economic disruptions, the U.S. dollar and U.S. assets have not generally been seen as a safe harbor in a storm and fundamentals, both in the U.S. and overseas could support a further fall in the U.S. dollar exchange rate.

Investment Implications

Experience teaches us that long-term investors should not try to make short-term market calls. The wild swings in the U.S. stock market in the first half of this year provide just one more illustration of this rule – investors who sold equities in April, at the peak of trade uncertainty, missed out on a dramatic rally in U.S. stocks in the weeks that followed. This rule also applies to currencies. Despite a backdrop that seems to favor further dollar weakness, there is no guarantee that this weakness will persist over the rest of 2025.

However, for most investors, there are three strong arguments for increasing exposure to non-dollar assets, such as international stocks, today.

First, America’s chronic trade deficit, which will not be remedied by tariffs, will tend to put downward pressure on the dollar, while slower U.S. economic growth and higher U.S. government debt will reduce the attractiveness of U.S. stocks and bonds, suggesting the likelihood of a longer-term dollar decline.

Second, U.S. equities remain much more expensive than their international counterparts, with the forward P/E ratio on the S&P500 running almost 50% higher than on the MSCI ACWI ex-U.S. and international stocks sporting dividend yields that are almost double those on their U.S. counterparts. While, these differences in valuation have grown over many years, reflecting “U.S. exceptionalism”, a reasonable question is whether investors are now overpaying for that exceptionalism.

Finally, even if it were an even bet whether the dollar and the exceptionalism premium would rise or fall going forward, investors are not positioned as if it were an even bet. After years of U.S. outperformance, American investors are heavily underweight international assets. With the 4^th of July fireworks still ringing in our ears, sentiment may prompt American investors to root exclusively for the home team. Prudence, however, suggests they should spread their bets to include international assets, partly because of the possibility of a further decline in a long-soaring U.S. dollar. 

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