The end of ‘U.S. exceptionalism’? Strategies to guard downside risk

When one hears the term ‘American exceptionalism’, for some investors, the first images that come to mind are perhaps that of a certain president and his inclinations towards jingoism. But the usage of the term outside of the U.S. has intensified over the last while, particularly when it comes to markets, where U.S. equities have outperformed handily.

Indeed, more than any other time in modern history, U.S. markets have benefitted from a strong influx of foreign capital (Chart 1). The impact has been profound, with U.S. equity market valuations now at levels that go beyond what is generally thought reasonable, while within the leading global equity index, the U.S. accounts for almost 70% of the weight, well over double where things stood a few decades ago.

Chart 1 – U.S. attracts more foreign capital than any other point in history

Source: BEA, BMO Global Asset Management, as of December 31, 2024.

Chart 2 – Two-year price return of selected equity indices

*In USD terms, prices only. Source: BMO Global Asset Management, as of December 31, 2024.

Now, there are several easily digestible reasons why the U.S. market captured the hearts and minds of investors worldwide. To start, U.S. economic fundamentals have been sound, with flexible labour and deep capital markets combining to deliver an enviable track record of productivity. That’s directly helped generate impressive earnings for American companies. Additionally, lower debt levels among U.S. households (compared to other developed markets) buttress a strong propensity to consume.

Those sorts of fundamentals form the bedrock of why the U.S. continued to draw in foreign capital. From the eyes of global investors, Japanese and European markets offer too low of a yield, with political risk for the latter becoming more of a risk going forward. And we haven’t even mentioned the liquidity of U.S. assets – which becomes very attractive during volatile periods. Add it all up, and the risk/return profile in the U.S. looks far better than it does in any other country.

4 reasons to reorient exposures

However, having said the above, the coast is certainly far from clear that investors will see another banner year for U.S. assets.

Instead, we see strong enough arguments that tell us that U.S. assets shouldn’t perform to the same degree that they have over the past few years. Being less enthusiastic about the theme of ‘U.S. exceptionalism’ means that we will be orienting our strategy for the coming year away from index plays and towards alternative investments and structured outcomes that are tailored towards generating cashflow. There are many reasons why we think this will be the optimal strategy to pursue.

The first is valuation. Certainly, this topic has gotten a lot of airplay already, but it’s worth going over the finer points at least one more time here. For the S&P 500, consensus estimates have large cap earnings expanding by around 10%.¹ But at the same time, the forward price-to-earnings (P/E) ratio is already at highs not seen since 2020. Assuming that the long-term relationship between nominal GDP growth and earnings holds, we see earnings growth in upcoming quarters closer to 6-7%—implying that our own estimate of forward P/E is actually closer to extremes last seen around 2000 (or the ‘dot com’ bubble).²

Again, this isn’t a clarion call to move out of broad risk on its own, but it does make us less enthusiastic about adding at the very least, especially as growth expectations are under pressure from the economic risk tariffs pose.

Chart 4 – S&P 500 forward P/E ratio over time

Source: Bloomberg/BMO Global Asset Management, as of November 30, 2024.

Second, the shift higher in long-end U.S. Treasury (UST) yields could portend increased market risks. Since the inaugural rate cut from the U.S. Federal Reserve for this cycle last September, the 10-year yield has shifted higher. That’s atypical behaviour that likely speaks to the view that the U.S. will be issuing more debt over the long-term and/or that the market views equilibrium growth levels in the U.S. as being higher than before. Regardless of which narrative is driving this, the simple takeaway here is that we’re in an environment where the U.S. 10-year yield is now above the earnings yield for the S&P 500. The last time this was a frequent occurrence was around the turn of the century – when the S&P 500 struggled to generate much in the way of momentum. Once more, this isn’t a sign of the apocalypse. Nevertheless, it does tell us that interest to diversify across the spectrum of U.S. assets should increase (away from equities and into bonds) as UST offer a better risk/return profile than equities do.

Chart 5 – U.S. 10-year yield is higher than the earnings yield of the S&P 500

Source: Bloomberg/BMO Global Asset Management, as of December 31, 2024.

The third reason is about revenue and spending plans over the course of President Trump’s term. Unlike the start of his first term, Trump is being handed a massive deficit (over 6%), and yet he is still expected to push through tax cuts for corporates – including an extension of the prior tax cuts under the Tax Cuts and Jobs Act of 2018. For markets, the pertinent problem here is how these will be funded—Trump’s claims that it will be through tariffs hardly seem viable. It may not seem like it now, but fiscal discipline is still important and markets will eventually punish any lack of effort to address this via long-end UST yields, which we’ve somewhat seen since September.

And when it comes to trimming the deficit, there’s a lot of hope being placed on the ability of the “Department of Government Efficiency,” or DOGE, to cut wasteful spending. However, when you comb through the numbers there’s actually very little that can be trimmed without curbing defense or mandatory (Social Security, Medicare and Medicaid) expenditures.

Finally, the fourth reason is a simple one to conceptualize and related to the first. The theme of U.S. exceptionalism might just be in the price already. The widening gap in fundamentals between the U.S. and the rest of the world is an easily digestible story that the market has been chewing on for some time now. The real surprise will be when that story changes and the gap begins to narrow, a theme that the market could run with for some time. There are several potential catalysts to watch for here—including fiscal stimulus in China targeted at domestic consumption, or a turnaround in the German business cycle led by pledges of more government spending.

Again, we still see compelling reasons to remain invested. Nevertheless, we’re recalibrating our strategy to be in line with a more ‘cautiously optimistic’ outlook. That means veering away from index plays and towards alternative investments and structured outcomes that are tailored towards generating cashflow. As such, we’ll be complementing or curbing exposure to broad index trackers, with high dividend and covered call strategies. These include the BMO Covered Call U.S. High Dividend ETF Fund, the BMO Covered Call Utilities ETF Fund and BMO Covered Call Europe High Dividend ETF Fund.

Additionally, given where current valuations are, protecting downside risks to core exposures that track U.S. large caps is essential. The BMO Low Volatility U.S. Equity ETF Fund provides diversification in high-quality U.S. stocks with lower volatility than the market, allowing holders to benefit in rising markets, while curb downside risk in the event of a drawdown.

Bloomberg, as of January 31, 2025. The inception dates for respective funds: BMO Covered Call U.S. High Dividend ETF Fund (Series F) = April 28, 2016, BMO Covered Call Utilities ETF Fund (Series F) = June 16, 2023, BMO Covered Call Europe High Dividend ETF Fund = April 16, 2016, BMO Low Volatility U.S. Equity ETF Fund = August 17, 2020.

¹ Bloomberg, as of November 30, 2024.

² Price-to-Earnings (P/E) Ratio: A measure of a company's share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company's stock. Forward P/E is a version of the ratio that uses forecasted earnings to calculate the ratio. A lower forward P/E ratio may indicate that a stock is undervalued, while a higher forward P/E ratio may indicate that a stock is overvalued.