The big theme in markets and in Mill Street’s work with clients recently has been the dramatic shift in leadership away from the US and toward the rest of the world, especially Europe. Risk appetite has weakened as US economic policy uncertainty has skyrocketed and the growth outlook has deteriorated, making equities riskier in our work.
Policy chaos unfolding at record speed
A lot of things have changed since January 20th, and in equity markets the biggest change has been the rapid reversal of what had been consistent US leadership relative to the rest of the world. This was true both in terms of equity market performance and relative earnings and GDP growth.
And while it will take time for the economic data to reflect the series of US policy mistakes that have been implemented or threatened in the last two months, the equity market is already responding, and our data show that equity analysts are already changing their earnings forecasts to reflect the worsening backdrop.
The extent of the policy mistakes being made by the Trump administration and explicitly or implicitly endorsed by Congress (despite many of them being illegal) is extraordinary, but a full discussion is beyond the scope of this document. But a few of the big ones include:
- Tariffs – huge new tariffs on many of the major US trading partners, including long-time allies, will be a massive tax increase that is already provoking countervailing responses that will harm both US importers and exporters, as well as US tourism. This reverses decades of falling tariffs and trade barriers globally that have benefited the US and the rest of the world as most countries realized that tariffs are an extremely inefficient and ineffective way of controlling global trade, particularly when applied broadly and haphazardly as they current are.
- Immigration – the ability of the US to both attract and integrate immigrants has long been established in economic literature as a strong net positive for the US economy, but is now is serious jeopardy, with negative implications for many industries that rely on immigrant labor and demand.
- Foreign policy – the US role as defender of much of Europe and Asia, and the corresponding benefit to the US economy and multi-national corporations, is moving rapidly in reverse. Europe is already moving to provide its own defense, at the expense of US companies and increasing the risks of conflict globally.
- Health and education – the US has long been a global leader in health-related research and development (though our health insurance system is open to considerable criticism) as well as higher education, with extensive benefits for both US citizens and many US corporations. That role is under direct threat amid massive cuts to government support for health and education.
Markets do not like uncertainty
The chart below shows the US Economic Policy Uncertainty Index we have been highlighting to clients recently. It is an index produced by Baker Bloom Davis that quantifies references to US economic policy uncertainty in hundreds of newspapers in the US and globally. We can see that after showing relatively low readings for most of the 2021-24 period, it has skyrocketed since November (first big jump was after the election, second big jump has been since inauguration), and especially since January, and is now back near COVID-era peak levels. This suggests that the US is facing a pandemic-level threat to the economic outlook (readings much higher than in the Great Financial Crisis), but one that is entirely self-inflicted and having far different effects on other countries.
Source: Mill Street Research, Bloomberg
The results of the surge in uncertainty can be seen in market valuations, volatility, and relative returns. Equity market volatility has increased significantly in recent weeks, and since volatility tends to be persistent in the short- to intermediate-term, this is a worrisome sign and one reason for our more cautious equity outlook.
Source: Mill Street Research, Factset
The price/earnings ratio for the S&P 500 based on consensus next-12-month earnings had reached elevated readings near 22 as recently as mid-February. But in recent weeks it has declined as uncertainty has risen, now just over 20. However, as the 10-year chart below shows, the P/E can go significantly lower if investors begin to fear a recession.
Source: Mill Street Research, Factset
The starkest shift in our work has been the reversal of US outperformance in relative returns and relative earnings estimate revisions activity. We track aggregated measures of equity analysts’ revisions (updates) to their earnings forecasts for over 6000 companies globally, including about 2400 US stocks. We can thus compare the proportion of analysts who are raising estimates versus lowering estimates on average across different regions (and sectors, styles, etc.).
The chart below shows our earnings revisions indicators for the US and for all other countries excluding the US. Revisions breadth is the net proportion of analysts raising versus lowering earnings estimates, averaged across all stocks in the region. The bottom section shows the relative return of the S&P 500 index versus the MSCI All-Country World Index Excluding US (ACWI Ex-US) index.
Source: Mill Street Research, Factset
We can see that until February, US revisions activity (red line) was better than the ex-US aggregate (blue line), even though US revisions had been gradually slowing as they tend to do later in an economic cycle. But in the last six weeks or so, we have seen US revisions accelerate to the downside, even while the ex-US earnings indicators turned higher. That is, the weakness in US revisions was not accompanied by a corresponding dip in other countries (as would typically be the case in a general global economic slowdown), it has been a US-specific shift accompanied by offsetting effects elsewhere, mostly in Europe where fiscal policy is becoming more supportive.
Thus the difference between the two (grey line, middle section) has shifted from solidly positive (favoring the US) to solidly negative (favoring ex-US) for the first time in quite a while.
And not coincidentally, the relative return series (purple line, bottom section) had been rising, signaling US stocks outperforming ex-US stocks, up until recently when it suddenly turned lower starting in early February. It has now given back all of the relative performance (~10%) it had achieved since a year ago in the last six weeks.
The rapid reversal in US fundamentals and returns relative to ex-US markets also aligns with a rapid shift in risk appetite within US equities. The chart below shows the relative returns of the S&P 500 High Beta Index (with ETF ticker SPHB) versus the S&P 500 Low Volatility Index (ETF ticker SPLV). Until early February, high-beta stocks (nearly half of the weight of which is in Technology) had been performing in line with or better than low volatility stocks. But in recent weeks high beta stocks have plunged while low volatility stocks have held not far from their recent all-time highs. The message is that investors are not selling all stocks across the board, but are retreating from the riskiest stocks in favor of the safer (less volatile) areas. Such moves can often be the first step before a broader move to sell equities generally if conditions do not improve.
Source: Mill Street Research, Bloomberg
Absolute and relative risks have risen for US equities
Markets are riskier now due almost entirely to the policy mistakes we worried about in our 2025 outlook comments, which are worse and coming faster than almost anyone anticipated. US stocks are particularly vulnerable to these risks given that they had become more expensive in recent years in response to the unusually good economic conditions (“soft landing”) seen in 2023-24, whereas ex-US stocks had been cheaper. Now that US fiscal policy is going in reverse while Europe is shifting toward more expansionary policy, the regional equity and earnings outlook has shifted dramatically.
Thus our guidance to clients in the last two months has been to scale back equity exposure overall (more fixed income) as risks have risen, and to scale back what had been a significant overweight in the US relative to ex-US markets, with Europe and Japan looking more appealing now. We continue to focus on our objective indicators of market behavior and fundamentals (earnings), while keeping in mind the politically-based instability and headline risk causing most of the recent changes, and the knowledge that the Fed will likely not be able to “save” the market this time.
Sam Burns, CFA
Chief Strategist