Make International Great Again: Time to (re)embrace international equity diversification

Every investor knows that diversification is a good thing for portfolio construction, yet this well-established, common-sense approach to investing has struggled with a nearly three-decade long outperformance of U.S. equities versus a broad set of non-U.S. equity markets (Figure 1). The recent decade even evolved toward an anecdotal paradigm where many investors folded to the view that there was no alternative (i.e., TINA “there is no alternative”) outside of U.S. equities. The danger in investing is to expect things to go on forever. Of course, nothing can last forever when it comes to picking winning stock markets.

The Trump Reset: challenging exceptionalism while waking up the rest of the world

U.S. equities recently unwound post-election gains as President Trump prioritized growth-negative policies (tariffs, DOGE – Department of Government Efficiency, border security) and U.S. growth expectations began cooling. Though it remains difficult to forecast Trump’s next move, one assumption we can make is that these policies are means to an end and necessary to achieve Trump’s America First agenda of balancing the budget and increasing domestic manufacturing. While this may seem like the worst-case scenario for risk assets unfolding, there are powerful trends emerging that offer opportunity for investors and are by-products of Trump’s America First agenda.

International equities are having a moment

International equities generally outperform when the USD weakens and global growth picks up. We have witnessed the first leg of this trade, reflecting a rerating of extreme valuations in Europe and China as U.S. growth expectations peaked while growth started to bottom elsewhere. The USD also peaked in January.

Figure 1: Total Return of U.S. vs Non-U.S. Developed Equities

Source: Global Financial Data, Bloomberg, BMO GAM. Data as of February 28, 2025.

Lasting periods of international outperformance have not occurred in over two decades (Figure 1). What is required is sustained USD depreciation and growth convergence led by non-U.S. countries. Tactically, we think USD has peaked, as U.S. growth downgrades keeps the U.S. Federal Reserve (“Fed”) rate cut cycle intact (Figure 2). The sum of Trump policies could prove most negative for U.S. growth than elsewhere even though the U.S. is least exposed to trade, driving a negative USD premium similar to what occurred for the Pound sterling (GBP) after Brexit. Finally, trade uncertainty is likely peaking, allowing currency premiums to fade and global growth to recover in the second half of the year.

Figure 2: USD has likely peaked if the Fed continues cutting

*target interest rate level (for a cycle of rate hikes/cuts) set by the Fed
Source: Bloomberg, BMO GAM, March 2025.

Furthermore, Trump’s protectionist agenda is incentivizing U.S. key trade partners to invest more in defense and implement more growth-friendly domestic policies. This is already playing out in Europe, where Germany has reformed its “debt brake” and passed massive spending packages on defense and infrastructure to the tune of 20% of GDP (gross domestic product) over 10 years. The EU (European union) has also backed a “ReArm Europe” plan to spend €800bn more on defense while loosening debt restrictions on member nations. Based on fiscal multipliers of 0.5 to 1.0, the impact amounts to several percentage points on GDP growth in the next few years.

In Canada, officials are not only raising defense spending but are discussing ways to open up barriers on inter-provincial trade, which could boost GDP by at least $160bn per year, diversify exports and open up pipeline capacity.

China is a poster child for U.S. decoupling. Facing years of export controls and tariffs, China has accelerated its own innovation, subsidized domestic industry and created closer ties with other trade partners. Faced with more tariffs, China is boosting stimulus as its economy emerges from its multi-year slump, raising its deficit target to 5%, the highest in 15 years, and prioritizing consumption growth. Chinese officials are again warming up to the domestic tech sector, still the only true competitor to U.S. tech and biotech and where AI-driven productivity is the second most likely place to materialize outside of the U.S. Relative to the U.S., Europe and Asia EM (emerging markets) also have the greatest exposure to China’s economic upturn.

Figure 3: Productivity gaps between U.S. are significant

Source: Haver Analytics, BMO GAM, December 31, 2024.

This policy rethink can be transformative in raising long-term bond yields, which is good for banks, and raising productivity, where gaps versus the U.S. have widened dramatically in the past 15 years (Figure 3). It comes at the same time the U.S. is pursuing policies that may weigh on productivity, through tariffs which hurts supply chains and makes capital expenditures (funds used to acquire assets) more expensive, and prioritizing domestic production, which can be more costly. In sum, higher growth prospects and bond yields help value-heavy indices like Europe and Canada.

Possible peace in the Middle east and in the Ukraine, where war dealt a significant energy shock, is an additional positive risk catalyst for non-U.S. equities. Lessons from the Ukraine war are also driving Europe to rethink its energy policy and devise ways to drive down energy costs which remain relatively high.

The case for regional diversification

We do not heavily discount U.S. growth resilience or other Trump policies around deregulation and tax reform, which are likely to come more to the forefront later this year. The main conclusion is the case for diversification, a pillar of investing, within equities has strengthened in our view, and non-U.S. equities generally provide nominal benefits (Figure 4).

Figure 4: Regional correlations* with U.S. equities show some diversification benefits

*Correlation shows the relationship between variables. Closer to +1/-1 means the variables move similarly/differently.
Source: Bloomberg, BMO GAM. Local currency, since 2010. Data as of February 28, 2025.

Portfolio implications: when strategic means tactical

We think long-term investors should pay most attention to factors that feed a strategic (i.e., multi-year horizon) investment hypothesis and avoid chasing short-term momentum. Looking beyond the policy shifts observed in the U.S. and elsewhere, which triggered the initial buying phase of equities since last October, valuation is adding to the long-term attractiveness of non-U.S. equities. Valuation discounts have the potential to narrow further while non-U.S. earnings have a chance to catch up as countries try to reduce productivity gaps.

Trump’s policies—greater protectionism and fiscal austerity—have the potential to drive a sustained period of USD depreciation by impacting long-term growth and capital flows. Moreover, the fiscal policy rethink may drive a rethink among global money managers, and relocation of flows could be meaningful. Annual net flows from abroad hit a record $1.4tn through the fourth quarter of 2024, driving the U.S. net portfolio investment position to new heights with signs of some reversal in the first quarter (Figure 5).

Figure 5: Record Foreign Inflows Drives the U.S. Portfolio Investment Position to New Highs

Source: Haver Analytics, BMO GAM, December 31, 2024.

In February, we recommended investors to start hedging USD assets (see “CAD Outlook: Trade turbulence offers contrarian opportunity to hedge USD exposure”). On equity exposure, long-term investors might consider EAFE over EM, preferring the stability of democratic institutions of the former. Europe and China look most attractive tactically, the latter which we have increased to a tactical overweight in our portfolios. On Europe, we recommend Europe equities unhedged, as the new policy regime is bullish (optimistic) for the euro currency and European returns are positively correlated with changes in the euro (Figure 6).

Figure 6: European equities tend to be positively correlated with euro

Source: Bloomberg, BMO GAM, March 2025.