- Pandemic-era shortages and rising geopolitical tensions have seen more countries turning inwards and focusing on their economic resilience and national security. All three of the world’s largest trading regions – the US, China and the EU – are pursuing policies to diversify the sources of their imports, both as a hedge against potential supply disruptions and to reduce vulnerability to geopolitical uncertainty. In this context, the Trump administration’s latest tariffs are just symptomatic of a more general fracturing of the global economy and increased emphasis on self-sufficiency, particularly in strategic sectors such as Defense, Technology and Healthcare.
- That said, while China and the US have continued to decouple, the world has grown increasingly more dependent on China and less dependent on the US in the past 25 years, according to IMF data. China’s growing importance in the world economy is reflected in its increasing share of global trade, both as an exporter and importer, and dominance in global supply chains. In turn, many countries rely on China as a key export market and source of imports.
- With the Trump administration pursuing a more confrontational trade policy towards the rest of the world and China increasingly being seen as a “systemic rival”,5 we think that most countries will double down efforts to diversify their supply chains, boost domestic production, and build strategic stockpiles. However, limited fiscal space might make such efforts increasingly difficult, especially given higher defense expense needs. Balancing economic and national security concerns with the need for open trade and cooperation is likely to remain a key challenge, with significant implications for long-term investing, in our view.
High valuations, trade uncertainty and geopolitical concerns warrant a more cautious asset allocation until year end, in our view. We are neutral on equities, underweight credit and overweight rates in the medium term. Given heightened policy risk in the US, we expect continued outperformance of Developed Markets ex US equities and favor high income solutions.
Base Case
Our central scenario is one in which US trade policy uncertainty continues to subside and recent geopolitical risks ultimately moderate, allowing inflation to stabilize and central banks to cut rates a little further. This would be supportive of risk assets globally, but downside risks remain elevated, warranting a more cautious approach. While the global economy may be less sensitive to oil prices than in past cycles, it is not immune. Uncertainty and energy price volatility, combined with the ongoing tariff shock, could still weigh on global growth. Overall, the recent escalation in geopolitical tensions adds to the risks facing the global economy.
Global Trade & Geopolitical De-escalation (Negative Inflation, Positive Growth)
A scenario where tariffs are reduced substantially or even removed entirely, and geopolitical concerns surrounding the Middle East dissipate, would be positive for global growth and disinflationary in the US. This would support risk assets globally and allow faster Fed cuts which would be welcomed by bond investors. That said, long-duration treasuries could remain volatile as lower tariffs reduce revenues and pressure public finances.
Key Implications
We believe investors can position for such a scenario by considering cyclical sectors, particularly those exposed to US tariffs such as autos, and global fixed income.
US Stagflation (Positive Inflation, Resilient Growth)
While not our base case scenario, inflation expectations could move sharply if tariffs were to be entirely passed on to consumers or geopolitical events drive energy prices considerably higher for an extended period of time, affecting their consumption habits and wage demands. While the reduction in trade uncertainty would see growth stabilize at below potential levels, the de-anchoring of inflation expectations could lead to a more permanent inflationary shock. In the event, the Fed would likely pause for longer, perhaps until 2026, and the risk of a rate hike would increase.
Key Implications
In our view, the best tactical inflation hedges in such a scenario would be non-traditional diversifiers like gold, trend-following hedge funds or private assets. That said, investors can also adjust their core exposure by favoring the short-end of the curve within fixed income, and high-dividend stocks within equities.
US Recession (Negative Inflation, Negative Growth)
In the event of a global tariff escalation, both consumers and businesses in the US would be hit hard, with a rise in the unemployment rate and a freeze in domestic investment pushing the US economy into a recession. While higher tariffs may lead to a jump in inflation at first, the weakening in aggregate demand and the labor market would ultimately dominate, easing inflationary pressures and allowing the Fed to cut rates more sharply.
Key Implications
Investors may consider pivoting to more defensive and dividend-paying stocks, extending duration by increasing exposure to government bonds and adding alternatives, such as multi-strategy hedge funds or gold.
OUTLOOK
Mitigating Regional Concentration
In an environment where the long-standing dominance of US equities is being reassessed, many investors are increasingly scrutinizing their equity allocations. The US now commands over 70% of the MSCI World index, which came at the expense of other developed peers like Europe and Japan. While this surge reflects superior US corporate earnings and tech-sector dominance, it also raises concerns about portfolio concentration risk. The mean reversion potential and structural shifts in global growth and policy regimes make a timely case for broader diversification into ex-US equities, in our view. As valuations outside the US appear more attractive, and monetary and fiscal dynamics evolve across regions, the marginal benefit of holding an overweight position in US equities is likely to diminish. We believe that investors should consider the long-term benefits of regional diversification, not just for risk mitigation purposes, but also given the potential upside in under-owned markets that are poised for recovery and structural re-rating.
Finding Value and Diversification in Global Equities
The growth gap between the US and other regions is likely to narrow in the medium term, potentially making non-US markets, including EM equities, more attractive. While tariffs might weigh on growth in Europe and China in 2025, a shift towards more fiscal stimulus may partly cushion the impact and boost potential growth in the years to come, making those markets more attractive. Additionally, ongoing pressure on the US dollar could dimmish the appeal of US assets for non-US investors. Looking at valuations, while they have expanded over recent months, Chinese, European and Japanese equities continue to be cheaper than US stocks, with P/E ratios of approximately 11.2, 14.7 and 16.0, compared to 22.3 for the US.6 From a correlation standpoint, Chinese and Indian equities exhibit lower correlations to US equities, which strengthens the case for regional diversification.
SOLUTIONS
