Mid-Year Outlook: International Stocks and Economy

This year investors, businesses and consumers have had to weigh the impact of tariffs implemented, paused, de-escalated and court challenged. The worst-case scenarios proposed in early April may be currently off the table, but trade uncertainty remains.

Some progress has been made toward trade deals, but there is more work ahead than has been settled. A U.S. trade court last week blocked the Trump administration's use of the International Emergency Economic Powers Act (IEEPA) for some tariffs, but a stay was granted as it goes through the appeals process, keeping tariffs in place while the legal battle continues. If the Trump administration loses the appeals and is unable to use IEEPA, it still has other means to increase tariffs—either through using Section 122 of the Trade Act of 1974 (which allows a 15% across the board tariff for 150 days) or Section 338 of the Tariff Act of 1930 (which allows for up to a 50% rate with no limit on duration). Additionally, sector-specific tariffs under Section 232 of the Trade Expansion Act of 1962 (like those currently on autos and aluminum, among others) and Section 301 tariffs under the Trade Act of 1974 (used on Chinese imports in the previous Trump administration) could be accelerated and broadened.

Trade negotiations could become more difficult, with potentially less urgency for countries to cut deals, particularly for those with lower sector-specific exposure. There may be some relief that tariffs could be reduced in severity or duration, but the next steps are complicated and this likely extends uncertainty for businesses and for the economic outlook.

U.S. trade deals have typically taken 18 months on average for both parties to sign an agreement, yet investors may be adapting. Despite the work on tariffs ahead, stock markets are now higher than on April 2. Trade deals with the U.K. and China have been viewed by market participants as progress, no matter how thin on substance. President Donald Trump's threat of a 50% tariff on EU imports on May 23 resulted in European stocks measured by the STOXX 600 Index dropping over 2%, but then recovering half those losses by the end of the day. The euro ended that day higher. On May 29, the S&P 500 Index was little changed upon receiving the news the court ruled to block new tariffs, as well as after the stay was granted to keep tariffs in place. Investors may be becoming desensitized to tariff news. While the economy may have yet to feel the full economic bite of the tariffs, their market bark is already fading.

Market volatility related to tariffs could return. During the first Trump trade war with China in 2018-19, tariff rates increased after both sides had agreed to work together during a 90-day reprieve, so tariff rates could increase again. Yet, there are signs that the Trump administration wants to make deals. As the year progresses and investors look toward potential resolution, market reactions to tariff news may become smaller as the economic and earnings outlook becomes clearer.

The Bloomberg consensus of economists lowered their estimates of global growth this year due in part to the trade war. Currently, the highest tariffs apply to imports from China into the U.S. and imports from the U.S. into China. As a result, these two countries are likely to experience the largest negative economic impacts. But there is positive news: despite the reduction in the growth outlook for 2025, neither the global economy—nor China or the U.S.—are expected to be in recession. Offsetting the predicted slowdown in the world's two largest economies, many smaller economies are expected to see an acceleration in growth in 2025.

Despite the trade war, eurozone data has come in better than forecast according to the Citigroup Eurozone Economic Surprise Index. There is support for continued expansion in Europe based on the OECD leading economic indicator for its four largest economies (Germany, France, United Kingdom, and Italy), which posted a record 30-month consecutive increase in April. This contrasts with the U.S. leading economic indicator from The Conference Board, which fell for the fifth straight month in April.

Importantly, the U.S. trade war has motivated countries outside of the U.S. to accelerate trade with each other. Already this year, the U.K. and India made a free trade deal, the U.K. and EU struck a landmark post-Brexit reset agreement, and China signed dozens of cooperation agreements with Vietnam and Malaysia.

After more than a year of central bank rate cuts, monetary policy stimulus may fade in the second half of 2025. Higher tariffs on U.S. imports could raise consumer prices and boost U.S. inflation initially, but over the longer-term, the potential for slower growth could be deflationary. Outside of the U.S., inflation could move lower, particularly if other countries don't retaliate by increasing tariffs on U.S. imports (inflationary) due to potentially slower U.S. growth and currency strength, which tends to reduce import costs and prices. We're still expecting rate cuts for most major non-U.S. central banks in the second half of this year, but the pace could slow. Japan remains an exception—a rate hike by the Bank of Japan is still possible in the second half of 2025.

Meanwhile, fiscal policy stimulus is gaining momentum. Canada has planned fiscal stimulus in the form of tax cuts and spending growth. Australia has touted tax cuts and support to households for energy costs. Japan has approved a $6.3 billion spending package to "fully support" businesses and households adversely affected by the U.S. tariffs. Perhaps, most notably Germany's speed in shifting away from austerity with sizable stimulus could be a watershed event that leads other European countries to follow. In the first half of the year, Germany passed what could become one trillion euros of stimulus. The historic package includes 500 billion euros for infrastructure to be spent over the next 10 years and an estimated 500 billion euros through the removal of strict budget caps above 1% on military spending and a proposed increase from 2% to 3% of gross domestic product (GDP) in the next few years. The combination of additional defense and infrastructure spending could add 1.5% to Germany's economic growth every year for the next 10 years and likely provide a new growth story in Europe.

The potential for the U.S. to back away from military guarantees for other countries is prompting NATO as a whole to increase spending. NATO is considering a commitment of 5% of GDP to be spent on defense by 2032 at their June 24-25 meeting, with 3.5% allocated to core defense and an additional 1.5% on cyber security and defense-related infrastructure.

A rising risk is that of the so-called "bond vigilantes"—investors who demand higher yields as compensation for excessive government spending. Signs of this were seen in yield spikes on longer-term government bonds in the U.S. and Japan during the second quarter of 2025. Rising government debt yields results in fiscal spending becoming more expensive due to increased debt service costs, hurts balance sheets of institutional holders of long-duration bonds (like banks, pension plans, or life insurers), slows economic growth and may cause policymakers to pare back other programs. At this time, increased government yields in Europe have not spilled over into currency weakness or stock market losses, perhaps because increased fiscal spending is viewed as a positive for economic activity.

Economic growth is important, but earnings drive long-term market performance. The first quarter earnings season in Europe was the best in years with 59% of companies in the Europe STOXX 600 Index beating estimates, four percentage points more than usual, according to data from earnings tracker London Stock Exchange Group (LSEG.)

The number of companies in the S&P 500 Index with downward earnings revisions to future quarters recently rose to a level comparable to the Global Financial Crisis and the COVID-19 pandemic. Yet for non-U.S. developed-market companies, revisions are still within a normal range and nowhere near past crises peaks, as you can see in the chart below. In aggregate, earnings estimates have continued to rise for the MSCI EAFE Index. A healthier economic and earnings cycle outside of the U.S. may have contributed to the MSCI EAFE Index outperformance in 2025 so far, relative to the S&P 500 Index.

After a decade of dollar strength, overweight positions of U.S. assets in many global portfolios, and unpredictable U.S. policy this year, investors seem to be gradually adding to non-U.S. assets, contributing to strength in non-U.S. dollar currencies. The potential for a rising fiscal burden in the U.S. is also weighing on the U.S. dollar. If tariffs reduce the U.S. trade deficit, that will likely result in fewer dollars held abroad that would need to be recycled into dollar assets, and could add pressure on the value of the dollar.

We believe the U.S. dollar could gradually decline due to the fallout of U.S. policies and as investors allocate to non-U.S. markets, but that doesn't mean it is a crisis—the dollar has often cycled between multi-year periods of strength and weakness in the past. The mirror of a decline in the dollar is a stronger foreign currency—¬for example, a stronger euro relative to the U.S. dollar means earnings denominated in euros exchanges into more dollars, which boosts returns for U.S. investors.

The outperformance of U.S. stocks for the most of the past 15 years and terms like "U.S. exceptionalism" resulted in many investors giving little consideration to the international exposure in their portfolios. The weight of MSCI EAFE countries in the broader MSCI ACWI (All-Country World Index) has been cut in half from around 40% at the end of 2009, when the U.S. outperformance began, to around 20% in November 2024. This shift also likely occurred in many investor portfolios, which are now probably underweight international relative to the longer-term strategic target.

Attractive valuations may persuade investors to reallocate money away from the U.S. in their portfolios. International stocks are currently valued close to their historical averages whereas U.S. stocks are currently over-valued relative to history, implying greater price appreciation potential for non-U.S. stocks.

By our calculations, it wouldn't take much of a shift out of U.S. stocks to make a big impact on returns for international stocks. The impact of these flows is like pouring buckets into teacups. For example, if just 1% of value was removed from the market capitalization of the 10 largest U.S. stocks in the S&P 500 Index and subsequently added to the 10 largest international stocks in the MSCI EAFE Index, it would increase their market cap by 7.5%.

Besides the numbers, it would be remiss to not discuss human nature. Investors tend to chase the trends in relative three-year rolling performance. Therefore, if international outperformance continues, the three-year mark for outperformance of the MSCI EMU Index relative to the S&P 500 Index would be reached this October and could prompt even more flows into international stocks. It's likely not too late to add international stocks to portfolios that remain underweight strategic targets, since these relative performance trends can last for years.

Despite a trade war between the U.S. and China, the largest country weight in the MSCI EM Index at 30%, emerging markets (EM) have been outperforming the S&P 500 Index this year. This echoes the performance during Trump's first term in 2017, where EM stocks outperformed in all four quarters. During 2017, policy uncertainty and trade war threats from the Trump administration did not derail global growth – similar to what economists are forecasting for 2025.

After China, the next largest weight in the MSCI EM Index is India, at 19%. Indian stocks underperformed the EM Index in early 2025, due in part to slower economic and earnings growth, as well as high valuations, but they are catching up after outperforming in the second quarter. India's growth may be stimulated if it further lowers tariffs and/or interest rate cuts begin to accumulate.

Lastly, EM stocks have perked up with enthusiasm for Chinese innovation. The release of the DeepSeek R1 open-source artificial intelligence (AI) model in late January was a wake-up call that China can be the source of innovation and resulted in an expansion of multiples for Chinese stocks. Productivity could improve as Chinese companies adopt AI, and lift earnings growth. Additionally, the Chinese government appears to have shifted toward a more business friendly environment. That said, Chinese markets have tended to have a bear market at some point during almost every year, so investors may want to keep a long-term view and positions small.

U.S. stocks have been sharply underperforming this year and global investors seem to be reassessing their international allocations. Reasons include the unpredictable and uncertain policy moves in the U.S., a stable economic and earnings outlook outside the U.S., a weaker dollar, attractive valuations for international stocks, the potential for a new growth story in Europe, and more optimism about emerging markets.

Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.