Following Trump’s election win, the markets rejoiced, partly fuelled by the unwinding of market hedges and the anticipation of more market-friendly policies from the new administration. Unfortunately, as with any “sugar high,” it just didn’t last. Since cooling in December, the S&P 500 has been stuck in a range around 6,000-6,100. This is an impressive feat, in our opinion, given the avalanche of policy announcements and talk. Sure, it has caused markets to bounce around much more, but they’re still within this range. Even the TSX, clearly more at risk of an escalating tariff conflict, is within one good trading session of its all-time high. The word “resilient” is fitting.
Helping the markets absorb all this headline noise without throwing a tantrum has been the economy and earnings. Economic momentum was decent as 2024 finished off, and not just in America, as the data picked up in many jurisdictions. This improving economic backdrop seemed to more than offset concerns over U.S. inflation, which has been reaccelerating for the past four months. A little more inflation is not hard to stomach when the economy is trending to the upside. Perhaps it’s even justified. Meanwhile, fourth-quarter earnings were decent, with the S&P posting about 10% earnings growth and 5% sales growth.
Unfortunately, this support backdrop may be waning. Economic data has started to soften, notably for the U.S., which had been so impressive over the past couple of quarters. Just look at 10-year Treasury yields, which have fallen from a high of 4.8% in early January to 4.27%, even with inflation still ticking higher. Additional evidence of a softening U.S. economy is showing up in multiple areas, encapsulated in the CitiGroup Economic Surprise Index. This captures how the economic data is coming out relative to consensus economist expectations. That descending line, well, it means negative surprises.
Earnings, too, are looking a bit squishy. 2025 and 2026 earnings estimates for the S&P 500 dipped lower during earnings season. That is the period when most companies are giving some level of guidance or comfort about the coming quarters, so softening isn’t great. On a positive note, the market is pricing in 10% earnings growth for 2025 and 12% for 2026. So, perhaps some minor downward revisions are tolerable. As long as they stay minor.
If the supportive fundamental backdrop continues to falter, will the market remain so sanguine about the non-stop policy announcements and uncertainty? With policy risk (more every day, it seems), economic growth, momentum risk and some earnings risk, this market is unlikely to stay in its three-month trading range much longer.
But if the market weakens, there could be some good news. Enter the “Trump Put”. Many readers have likely heard of the “Fed Put,” or the more personalized versions depending on the Chair, such as the “Greenspan Put” or “Powell Put”. It is the widespread belief by market participants that if the economy or market falls too much, they (the Fed) will come to the rescue with more and more stimulus. The “put” part comes from the options market, as a put option can be structured to create portfolio insurance to limit the downside. Hence, “Fed Put”.
President Trump appears to measure his success, or the success of his policies, based on what the S&P or market is doing. In fact, during his first term, at times when markets reacted negatively in response to policy, the policy was often adjusted or even reversed. We experienced a micro episode of this on the morning of February 3rd, after the Mexico and Canadian tariffs were signed into law over the weekend. Including the Friday afternoon market slide, when it appeared the executive order was certainly going to be signed on the weekend and the market open on Monday, the S&P 500 dropped over 3% from 6,115 to 5,925 over a combined four hours of trading. And what happened next? Trump deferred the tariffs for a month, and the market bounced back to over 6,000, recovering fully a few sessions later.
The question then becomes how much market weakness is required to see a pivot from the flow of policy announcements from the administration. Or for those options-savvy folks, where is the put strike price? Clearly, it is an unknown, but the crux is that a drop in the market may well trigger a cooling of policy risk. Some policy reversals and no new market unfriendly policy announcements could well help the market recover from its weakness. Following the same line of logic, perhaps the rapid-fire onslaught of policy announcements was partially emboldened by a market that had proven resilient.
To be clear, we’re not saying policy announcements or Trump can save or control the market. Earnings, the economy, confidence, rates, yields and policy all have an impact; it’s cumulative. But if there is enough market weakness, for whatever reason, policy reversals or softening would likely be welcomed by the market. Even a holiday from new policy announcements would be nice.
If you’re wondering what guardrails there are for the new U.S. administration, it may well be the market. One month done, 47 to go.
Europe's Market Resurgence
Two months into 2025, international equities are off to an impressive start. Leading the charge across developed markets is Germany (+13% YTD), with the rest of the European market not far behind. The MSCI Europe index is up 11% year-to-date in Canadian dollar terms. From our perspective, we can let out a relieved “about time!” Throughout last year, we advocated for an overweight position in international equities. The thinking wasn’t wrong – just early. Investors are increasingly reassessing the “U.S. exceptionalism” thesis, with cracks forming along the AI-defined edges. As a result, there is growing interest in international diversification and the potential for higher returns outside of the U.S.
This renewed interest has been a long time coming, but two or three months do not make a trend. Below is a sobering chart showing the relative performance of the MSCI Europe versus the S&P 500 over the past 25 years. The recent outperformance barely registers 18 years of underperformance. Being overweight in international equities is still a contrarian trade – it is far from crowded and one we believe has the potential to continue.
On a near-term basis, you could see some pullback. The weekly momentum of the relative trade is becoming slightly overbought, and a reversal is normal after such an extreme oversold level in Q4. The speed of Europe’s rebound has been remarkable. Since early December, the European advance has quickly narrowed the gap in trailing one-year returns.
Developed markets, led by Europe, are showing renewed momentum. Several key factors contributed to this shift. Monetary policy in the Eurozone has become significantly more relaxed. The ECB has now cut its target rate by 125bps and is expected to continue to cut another three times this year. There is also a distinct possibility of peace, or at least a ceasefire, in Ukraine, which could pave the way for rebuilding efforts and an economic boost to the region. Additionally, Germany’s recent elections have resulted in a more pro-business government promising to revitalize economic growth, lower energy prices, and increase infrastructure spending. All in all, the economic news in the region has become more favourable.
Valuations Remain Key
At just 14.8x estimated earnings, European valuations remain attractive compared to the S&P 500, which trades at 22.1x earnings – a 7.2-point premium. However, this is not an apples-to-apples comparison. Structural differences justify some of the valuation disparity. Europe has significantly less large-cap tech exposure (-20%) and more exposure to financials (+8%), industrials (+10%), and materials (+5%). These are historically lower valuation multiple sectors, and this relative sector tilt makes European markets more cyclical. More cyclical trade implies closer ties to China and the global economy.
The chart below outlines the relative forward price-to-earnings ratios of the MSCI Europe Index and the S&P 500 across all sectors. The U.S. is more expensive in nearly every sector. The largest valuation gaps are in financials (the largest sector in Europe), as well as utilities and energy. However, not all sectors follow this trend – health care and industrials trade at a premium in Europe. Different industry dynamics are at play here. For instance, within the industrial sector transportation stocks, which trade at a low price-to-earnings ratio (P/E), are at a much smaller weight compared to the U.S. Relative to the U.S., Europe is cheap, and relative to its own history, Europe is still attractively valued, trading roughly in line with its 10-year median valuation while the U.S. is trading at a substantial premium to its historical valuations. While lower growth expectations, investor sentiment, and structural economic factors do explain some of the gap, the magnitude of the valuation gap across most sectors remains extreme.
Earnings Growth Improving
Relative earnings growth expectations play a critical role in valuations. The U.S. already has decent earnings growth priced in, which helps justify its higher valuations. Meanwhile, international equities – led by Europe – are seeing earnings estimates improve. European earnings growth expectations have risen substantially, shifting from negative in 2024 to solid projected growth over the next few years. This narrowing earnings gap should drive further inflows into international equities.
Our Outlook
A weak start to 2025 for the U.S. bodes poorly for its full-year prospects relative to global markets. Historically, the U.S. has outperformed the rest of the world in 24 of the last 35 years (70% of the time). However, in the six instances when the U.S. underperformed by this magnitude by the end of February, it never managed to reclaim the lead position by year-end.
The ongoing market rotation reflects a growing interest in international equities, supported by attractive valuations, improving earnings estimates, and a clear sentiment shift. Risks remain, particularly potential trade tensions and tariff threats between the U.S. and Europe. However, we continue to believe in the positive outlook for international equities and the benefits of diversification. Within our multi-asset portfolios, we favour a mix of both active bottom-up allocators and cost-effective passive exposure to capture the unfolding opportunities in international markets.
Market Cycle & Portfolio Positioning
At the moment, we are living in a conditional world that is full of “ifs”. As of today, the global economy is doing rather well. There has been an uptick in global manufacturing activity, with 10 of the 16 more important country PMI data surveys above 50, representing rising activity. This is roughly the highest reading since early 2022. The Canadian economy just posted a 2.6% growth rate for Q4, which brings the quarterly average to a respectable 2.4% for 2024.
The giant “if,” of course, is tariffs: timing, magnitude and breadth. If they’re as draconian as the headlines imply, it likely means a Canadian recession and a big blow to global growth and trade. If they’re tempered, there’s less of a negative impact. If they're delayed or softened more, there will be even less of an impact. Many twists and turns lie ahead.
Let’s start with the good news: Earnings revisions and growth have moved higher for international equities. We have written on the improving earnings growth for international equity markets a number of times over the past few months. While earnings growth is still slower than the U.S., international equities, notably in Europe, certainly are getting the most improved scorecard so far in 2025. Add in the low valuations, and it’s compelling, and that is helping drive international markets higher so far this year. In case you haven’t noticed, the Euro Stoxx 50 is up 11% year-to-date compared to a paltry 1% for the TSX and 0% for S&P.
Offsetting this good news for market cyclical indicators is softness in the U.S. economic data. Momentum in housing appears to be waning, one of the more cyclical components of the economy. The other cyclical component, manufacturing, has improved. We are not celebrating this, though, as it would appear many companies have been getting in orders ahead of potential tariffs. This may have front-loaded manufacturing activity in Q4 and so far in Q1. The broad Citigroup economic surprise index has turned negative, and Consumer Sentiment, too.
Sentiment is always hard to capture, and often, this “soft” data from surveys does not follow the hard data. Sometimes, people say one thing but do another, in case you haven’t noticed. This is most evident this week in the American Association of Individual Investors (AAII). This survey, which dates back to 1986, asks investors their expected direction of the S&P over the next six months. This week, 60.6% were bearish, an extreme reading. Only 6 times (out of 1,960 weekly surveys or 0.3%) have investors been this bearish.
Normally, this is a contrarian indicator. In other words, when everyone is bearish, it has historically been a buying opportunity. The problem is that all those past extreme bearish readings came with markets already down 10, 20, 30 or even 40%. When this past week’s survey was conducted, the S&P 500 was down a mere 2% from its all-time high. Everyone is unhappy and bearish, but nobody’s selling. This is one weird market.
At the overall portfolio level, there were some changes in early February. We reduced preferred shares exposure and increased diversifiers. This does tilt us a little bit more defensive. While equities are neutral, our positioning among equities has a defensive tilt. This includes more equal weight for U.S. exposure. It's a bit more on the value side and mild overweight international.
On the bond side, we are a bit underweight, with a tilt towards higher credit quality. Duration is at the higher end of our historical range, as we believe yields will come down further on softening economic momentum. Additional defense comes from our diversifiers, which include volatility management, alternative yield and gold exposure.
Higher cash is earmarked to be opportunistic should some market weakness develop.
Final Note
2025 is a noisy year that will likely have many twists and turns. The next big one could come in early March as the tariff implementation returns for a second attempt. While markets have remained resilient, our concern is that softening economic and earnings momentum may weaken their fortitude. Could a big-enough market drop reverse the tariff risk (aka the “Trump Put”)? Maybe, but that is not going to be a pleasant experiment.
In the meantime, defense appears to be the prudent tilt. Perhaps the Eagles’ defense winning the championship over the Chiefs’ high-powered offense applies to markets in 2025. We will see.
— Craig Basinger, Derek Benedet, and Brett Gustafson
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Sources: Charts are sourced to Bloomberg L. P.
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