March 2025 Market Commentary

March 2025 Commentary

Is it Time to Overweight International Equity Exposure?

In our December 2024 Market Commentary, we discussed the overvaluation of the S&P 500, especially mega-cap technology, and the fact that we would be watching other areas of the market, including international, for opportunities to invest at more attractive levels of valuation. While small- and mid-cap stocks have lagged the S&P 500 year-to-date, value has outperformed growth and international has outperformed the US significantly over the first two months of 2025. As of end February, the S&P 500 is up 1.4% while MSCI EAFE (Unhedged) is up 7.3%. International performance has been particularly strong in the Eurozone with Germany (DAX) up 13.3%. Note also that Information Technology (-4.19%) and Consumer Discretionary (-5.41%) are the weakest sectors while more defensive sectors like Health Care (+8.38%) and Consumer Staples (+8.07%) are among the strongest sectors. Figure 1 shows the local currency year-to-date performance of major global equity markets.

Figure 1

Source: Bloomberg, AAFMAA Wealth Management & Trust LLC

Is this trend in the relative outperformance of international equities over US equities sustainable? Is it an opportunity to extend exposure to international equities or will this period of relative outperformance turn out to be short-lived like many we’ve seen since the mid-2000s?

Our Current Stance on International Equities

Our current preference is to allocate to international equities tactically rather than hold a strategic or long-term allocation. This preference has evolved since the mid-2000s when US companies were less global in nature and the relative risk and return of international and US equities were more in balance. In 1990, if we looked back 20 years at the return, risk, and correlation between US and international equities and calculated the optimal weight of international (that is, what allocation to international would keep return at the same level, but lower the risk), the allocation would have suggested 53.2% US and 46.8% international. At that time, 20-year correlation between the S&P 500 and EAFE was 49%, and the return/risk ratios were quite close at 0.74 and 0.75, respectively. Calculations that date back to this period are the reason many advisors will suggest a permanent allocation to international equities regardless of prior years’ returns or market environment. It is important to remember that investors can use different time periods, or input their own forward-looking risk and return assumptions, to calculate optimal portfolio exposures. Keep in mind, these exposures can vary significantly based on the time period or assumptions used. Regardless, a strategic allocation to international equities has been a significant drag on investment returns over the last 20 years.

If we fast forward to the late 1990s, a significant structural change took place in the United States that has impacted the relationship between US and international equities for more than 20 years now. The late 1990s to mid-2000s brought in a wave of US technological innovations that differentiated the US from the rest of the world and continues today. With the technological innovations came a secular improvement in US profit margins, a rise in concentration in Information Technology, a skew towards larger capitalization, and a factor skew towards growth over value. The US has outperformed international markets since this structural shift. Figure 2 shows the rolling 24-month relative returns between international equities (MSCI EAFE) and US Stocks (S&P 500). Notice that prior to the mid-2000s there are frequent periods of sustained international outperformance. However, since the mid-2000s, there are almost no 24-month periods where international outperforms, and those that do exist, are small in magnitude and limited in duration.

Figure 2

Source: Bloomberg, AAFMAA Wealth Management & Trust LLC

The sustained period of low interest rates following the Great Financial Crisis fueled the growth in US Information Technology and the skew in growth versus value. Today, the US is almost 65% of the global investable market, and Information Technology makes up 30% of the S&P 500. In comparison, Europe, the Middle East and Africa (EMEA) and Japan combined are 22.9% of the global investable market, and Information Technology is only 8.34% of the MSCI EAFE Index. The extraordinary earnings growth in US Information Technology has driven the outperformance of US equities versus international and that outperformance has occurred with lower volatility. Indeed, if we do the same exercise today (January 31, 2025) as in the previous section, where we calculate the optimal mix of US and international equities based on the asset returns, volatilities, and correlations over the prior 20 years, we find that the optimal mix is 100% US equities and 0% international. Remember that a Markowitz-efficient portfolio is one where diversification cannot lower the portfolio’s risk for a given level of return. In other words, simply adding international equities to a portfolio does not make the portfolio more diversified if it does not reduce risk. Over the previous 20 years, international equities have been highly correlated with US equities with lower returns and higher risk, so it is logical that the optimization does not include an allocation to international. Figure 3 shows the rolling 240-month correlation between the S&P 500 and MSCI EAFE as well as the 240-month rolling return/risk ratio for each index. Notice that since 1990, the correlation between the two indices has risen from 50% to 85% and at the same time the US has opened a significant efficiency gap (higher return per unit of risk).

Figure 3

Source: Bloomberg, AAFMAA Wealth Management & Trust LLC

What’s Driven the Short-term Outperformance of International Equities in Early 2025?

Since the beginning of this year, the market has broadened out and diversification is paying off. This is true by geography, sector, and theme. What’s driving the outperformance of international versus US so far in 2025?

Positioning. After the S&P 500 was up more than 50% over the last two years and price earnings ratios rose to extreme levels, it’s logical that some rebalancing and reduction of underweight international equity positions took place. Alongside positioning, measures of sentiment coming into the new year suggested US markets were overbought relative to international markets.

Concerns Surrounding the AI Narrative. Q4 was the first earnings quarter in two years where revenues did not exceed estimates. The deceleration in earnings growth generally and specifically in NVDA finally began to weigh on the market. As of the end of February, NVDA is down 7.0% and the Bloomberg Magnificent 7 Total Return Index is down 6.5%. In addition to slowing earnings growth, the emergence of DeepSeek as a cost-efficient large language model has made the market rethink the value of the huge AI capital expenditures seen from US companies. DeepSeek has also been a key driver in the relative outperformance of Chinese equities year-to-date.

Ukraine Ceasefire. Since the beginning of the year, flows into European equities have been at multi-year highs. One driver of this flow has been the recent rise in the probability of a Russia – Ukraine ceasefire. A ceasefire could benefit Europe in terms of reducing energy prices which would drive down electricity costs, lower inflation and strengthen consumer confidence. Economists predict this could boost European GDP by 0.2% - 0.5%. Additionally, European Industrials would be the big beneficiary of the Ukraine rebuild that would take place following a ceasefire. You could argue that European markets have already rallied on this, and a peace deal is far from certain.

What Might Drive Sustained Outperformance of International Equities?

In the previous section, the factors we addressed were an impulse for short-term outperformance of international equities. What might drive sustained outperformance of international over US? Many cite the valuation gap between US and international as the driver of recent performance, but we know valuation gaps can remain large for long periods of time. Indeed, value has underperformed growth over the last 20 years. Therefore, the valuation gap that exists between US and international markets would not by itself be sufficient to warrant a recommendation to significantly increase international exposure. Only a shift in underlying fundamentals will narrow the valuation gap. Figure 4 shows the current and forecasted GDP growth for the US, Eurozone, and Japan.

Figure 4

Source: Bloomberg, AAFMAA Wealth Management & Trust LLC

While GDP growth is forecasted to narrow in favor of the Eurozone and Japan, the difference in growth remains significant. Our focus will be primarily on data which might suggest a further narrowing of growth expectations between the US and the rest of the world.

Relative Inflation and Interest Rate Trends. In prior periods when international outperformed US, the environment could be characterized as one where inflation drove interest rates relatively higher in one region and negatively impacted growth and earnings. Inflation has remained stubbornly high in the US and the rate cut expectations that existed in Q4 have been reduced toward fewer cuts over a longer time period.

Impact of Tariffs and Market Uncertainty. Whether tariffs will be implemented, against which countries, and to what degree remains uncertain. The impact of tariffs will vary for each country so it is speculation only at this point what the relative impact will be for the US versus the rest of the world. Certainly, tariffs would eventually have an impact on inflation and exchange rates, which are factors that we will monitor. However, the uncertainty surrounding tariffs and trade policy is already having a direct impact that seems to be a global negative but has, to date, more negatively affected US equities. Policy uncertainty has already been reflected in Retail Sales (-0.9% in January), Consumer Spending (-0.2% in January), and Business Confidence. The 2025 Bloomberg Consensus real GDP growth forecast for the US has been lowered to 2.3% and many economists have Q1 2025 running significantly below this level.

Relative Fiscal Policy. What’s happened post-election in Germany is perhaps most interesting in terms of being a factor that could sustain the outperformance of international equities versus US equities. With Merz’s CDU/CSU winning the national election, there is potential for a significant shift in German policy. To begin with, the German government has decided to ease its strict debt limits, or “debt brake,” that limited new borrowing to 0.35% of GDP. This fiscal policy has weighed on Europe for over a decade. The new German government has acted quickly with a EUR 500 billion fiscal spending package dedicated to upgrading infrastructure over the next ten years (this would be equivalent to 1.2% of 2024 GDP per year over the next 10 years). Interestingly, this German fiscal policy shift is happening at a time where the US is undergoing fiscal consolidation.

Relative Performance of Global Technology versus Global Financials. In a previous section we discussed that Information Technology had grown to 30% of the S&P 500. The dominant sector in MSCI EAFE is Financials which is 23% of the index. Further momentum in the outperformance of global financials relative to global technology would suggest a longer-term continuation of the trend in international versus US and value versus growth.

Two months does not make a trend, and the recent uncertainty generated by US tariff policy has muddied the water, therefore we are not ready to suggest a general overweighting of international equities. The relative performance so far this year is significant so we will continue to monitor the factors discussed and extend exposure to international equities when the macroeconomic environment is supportive, and we find equities consistent with our investment philosophy.

Yours in trust,

Parker

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© 2025 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal. No information provided herein is intended as personal investment advice or financial recommendation and should not be interpreted as such. The information provided reflects the general views of AAFMAA Wealth Management and Trust LLC but may not reflect client recommendations, investment strategies, or performance. Current and future financial environments may not reflect those illustrated here. Views of AAFMAA Wealth Management & Trust LLC may change based on new information or considerations.