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Written by: Nelson Yu
Global equities faced fresh challenges in the first quarter of 2025 amid growing trade-war concerns and developments in artificial intelligence (AI). Bouts of volatility and an increasingly cloudy outlook underscored the importance of focusing on diversification, valuations and company fundamentals.
After a promising start to the year, global equities lost momentum in February and March (Display). The MSCI ACWI Index of global developed- and emerging-market stocks fell by 1.3% in US-dollar terms during the first quarter, as regional returns diverged. Market returns broadened, as evidenced by the S&P 500 Equal Weight Index’s outperformance of the cap-weighted S&P 500.
Two developments fueled volatility. First, the Chinese company DeepSeek unveiled a new AI model in January that undermined confidence in the earnings prospects of the Magnificent Seven US mega-caps. Second, US policy uncertainty rattled markets, in particular, the potential impact of President Donald Trump’s tariffs on economic growth and businesses. After taking office in January, Trump zigzagged but ultimately imposed levies on all imports from China and on select goods from Mexico, Canada and the European Union, all of which announced retaliatory tariffs.
Regional, Sector and Style Trends Shifted
The lack of clarity around trade policy prompted a divergence in regional returns. In a sharp reversal from long-standing trends, European and emerging-market stocks outpaced US equities during the quarter by a wide margin (Display, above). The MSCI Europe ex UK Index gained 10.7% in US-dollar terms. By contrast, US large-caps—the clear market victors in recent years—gave ground, with the S&P 500 down 4.3%.
Continuing a trend that began late last year, the dominance of the US mega-caps waned. DeepSeek’s cost-efficient model raised questions about future AI spending, triggering a sell-off of the Magnificent Seven that dragged technology stocks down 11.6% (Display). Energy and utilities led sector gains in the quarter, while healthcare stocks rebounded from a weak 2024. Lower-volatility stocks did well as investors sought safe havens. Value stocks, which have underperformed growth stocks in recent years, also benefited in the broadening market.
The Complex Effects of a Trade War
The policy conundrums that have dominated headlines aren’t going away soon. In particular, the Trump administration’s on-again, off-again approach to tariffs has left import-dependent US firms susceptible to volatile price swings, while exporters around the world also feel the effects. Many companies are struggling to advance investment plans while the tariff regime remains fluid. But uncertainty might ease if a more systematic approach to tariffs takes root, which could quell investor anxiety, despite concern about the economic fallout of a trade war.
Trade strains and geopolitical risk, from hostilities in Ukraine and the Middle East to China-Taiwan tensions, have threatened to rekindle inflation and muddied the interest-rate outlook. During the first quarter, the US Federal Reserve and Bank of Japan held off on monetary easing, while the European Central Bank cut its benchmark rate 50 basis points to 2.5%—near its long-term target.
For economies and companies, the outcomes of a prolonged trade war will be complex. For example, even Trump has acknowledged that the US could face a recession. That said, the US economy isn’t particularly trade-sensitive, and some companies are more tariff-resistant than others, depending on their industry and operational footprint. Some global companies with US operations might even benefit from tariffs. Examples include European and Japanese electronics manufacturers and consumer goods companies with a large US manufacturing presence.
Expanding Investment Horizons
Investors, too, face complicated challenges with policy uncertainty at a near record high while equity markets broaden. We think the time is right to reevaluate style and regional exposures, particularly as many investors became overweight US growth stocks in recent years because of the Magnificent Seven’s prior dominance.
Defensive equities could add breadth and fortitude. By investing in high-quality stocks with stable trading patterns, a defensive strategy can help reduce volatility created by political, technology and macroeconomic risks. Value stocks offer diversification and still trade at deep discounts to growth stocks. While value stocks are perceived as vulnerable to economic cycles, we believe investors can find undervalued stocks with attractive free cash flows and business attributes that can drive earnings, even in a more sluggish economic environment.
Regional diversification deserves attention. European equities may finally be finding their footing, even as the Russia-Ukraine war remains an ongoing risk. Equity valuations in Europe are still attractive versus US peers, and the average European company beat consensus expectations by 3% during fourth-quarter earnings season. There are even signs of a reversal in outflows from European stock funds over the last three years. Selective investors can find European companies with consistent earnings growth and quality businesses that are more resilient to regional macro and geopolitical risks.
Emerging markets are also showing signs of life and offer hidden opportunities. Some of the biggest players in the global artificial intelligence (AI) supply chain are based in emerging markets. Earnings estimates are trending upward across the developing world, which accounts for 90% of the world’s population and roughly half of global GDP. And our research shows that missing out on an EM recovery could be costly for investors.
Is a Realignment of Earnings Underway?
Recent shifts in equity return patterns call for a closer look at longer-term earnings trends. Over the last 15 years, US corporate earnings growth has outpaced that of non-US companies, represented by the MSCI EAFE Index. However, before 2010, that wasn’t always the case. In fact, our research shows that in three of the four decades since 1970, non-US earnings exceeded US earnings (Display).
This year, US corporate earnings growth is expected to come closer in line with earnings growth of the rest of the world. Meanwhile, equity valuations outside the US are still at a meaningful discount, based on 2025 forecast earnings (Display).
To be sure, even after a tough quarter, we think US stocks remain integral to any diversified allocation. For the last 60 years, US earnings growth has consistently risen, overcoming major economic and geopolitical shocks. Long-standing US advantages—from innovation to education to corporate culture—remain a potent force for equity returns. But how you access those returns matters. As we see it, a US allocation with disciplined active portfolios across the style spectrum is the right way to tap into a changing market.
Sharpening Focus on the “Magnificent Others”
Steep first-quarter declines of the Magnificent Seven have reminded us of the risks of concentrated positions. While the mega-caps include world-class companies at the forefront of the AI revolution, even great companies can pose investing risk. We believe each name should be held in accordance with a portfolio’s philosophy and at appropriate weights, as disruptors themselves can be disrupted.
In the first quarter, DeepSeek demonstrated AI’s disruptive effects on companies and portfolios. As the long-term effects of this technology evolve, we think investors should evaluate opportunities as they do other companies—by doing research to uncover sustainable business models and long-term profit potential. And we continue to see attractive opportunities among what we call the Magnificent Others—high-quality businesses scattered across sectors and styles that have sound balance sheets and consistent earnings streams.
Zooming Out on Volatility: Perspective Matters
Of course, diversified portfolios aren’t immune to volatility. Yet we think some perspective can help investors cope with turbulent markets, after the S&P 500’s peak-to-trough decline of 10.1% in the first quarter of 2025.
In any given calendar year, US stock investors can expect to see sizable negative moves. In fact, since 1980 the S&P has experienced an intra-year peak-to-trough drawdown of 14%, on average. Despite market disruptions—from economic crises to a once-in-a-generation pandemic—the S&P 500 finished higher in 36 of the past 44 years (Display).
The past quarter has been instructive on many fronts. We’ve seen that valuations do matter, as shares of the expensive mega-caps pulled back. Another lesson: consensus views can be dramatically wrong, such as the conventional wisdom at the beginning of the year that Trump’s policies would deliver an unequivocal win for US businesses and stocks.
In this changing environment, maintaining a diverse geographic portfolio can help cast a wider net for earnings growth—which can also help investors cope with inflation. Sticky inflation means our assets must work harder to generate returns, and inflation typically leads to higher nominal earnings, which drive stock market returns. That’s why equities have a long history of delivering positive real returns, above the inflation rate.
We’ve also been reminded that volatility is part and parcel of long-term equity investing—and diversification is one of the best antidotes. Investors should gird for more market turbulence and policy uncertainty, particularly around the pace, level and industries affected by tariffs. But there are silver linings in this year’s cloudy market: a less-concentrated equity backdrop that could reward patient equity investors who remain focused on finding companies with strong fundamentals, and more attractive valuations for those who stay invested to achieve their long-term goals.
Related: S&P 500’s Early Slump: Is Volatility the New Normal?