Broadening Out From Trump 2.0

Investors are grappling with shifting US trade policy that has introduced exceptional uncertainty to markets and the world economy. Gain insight into what’s driving the volatility, how we got here, and how a barbell strategy may help you navigate the changing tides.

On the heels of the Trump Administration’s on-again, off-again approach to tariffs, stock market volatility is back. Geopolitical secular trends and new questions about US exceptionalism make a compelling case for rotating some money out of the US. Investors considering doing so may want to look at several investment sector and country strategies that can potentially help them manage risks while still pursuing US growth.

Investor sentiment is moving away from the US Technology sector and US equities more broadly to European equities, as evident in ETF flows through April 2025. Given the uncertain path of US policy, it’s critical for investors to broaden their investment exposure and diversify to prepare for a wide range of possible outcomes.

To help investors do just that, we analyzed whether a sector barbell approach using US defensive sectors as well as European Financials or Industrials could help investors broaden out from US Tech to achieve better risk-adjusted returns. Similarly, we evaluated barbell approaches to broad indices to see if pairing Europe with the US, or the market-cap weighted All World paired with the fundamentally weighted All World, could help investors capture potential US growth but with an improved risk profile.

Volatility Is Back

The current Trump Administration’s “Liberation Day” reciprocal tariffs delivered a significant shock to markets and has exacerbated familiar market fears about inflation, stretched tech valuations, and the impact of tariffs in particular. The market turmoil since has caused the VIX (the fear gauge) to spike to levels around 40 (Figure 1).

Trump’s tariff strategy in his first term had been narrowly focused and sector-specific. By contrast, tariffs announced on Liberation Day were a dramatic escalation: with a universal 10% blanket tariff on all imports, plus global reciprocal tariffs including up to 36% on Chinese goods — a figure that has since climbed to 125%. While the reciprocal tariffs on all countries except China were paused on April 9, tariff policy will likely continue to evolve.

Trump’s process of policy change and reversal has created a climate of unpredictability, undermining business planning, distorting markets, and causing reactionary supply chain decisions. The potential impact of tariffs on pricing and demand could show itself later this year, but the uncertainty Liberation Day has sown is causing turbulence, and stock volatility could persist for some time.

Additional factors are feeding the uncertainty.

Soft Landing Challenged

In this post-pandemic era, the US economy has recovered well and seemed on track for a soft landing, having avoided a recession so far. While inflation rates skyrocketed owing to supply-side shocks, they’re now falling towards the medium horizon 2% target. The Federal Reserve (Fed) is cautiously lowering interest deposit rates at a lag currently at 4.33% (Figure 2). It is quite marked compared with the level of inflation and rates under Trump’s previous administration.

Trump 2.0 tariff policies, if too aggressive, could lead to potential stagflation and disrupt the current soft landing scenario.

Tech Bubble Fears

A second factor contributing to heightened market vulnerability is market concentration owing to the incredible US tech performance during 2023 and 2024. The net return of the S&P 500 Information Technology Index was 114.6% over the two years versus 56.5% for the S&P 500.¹ Worries about a potential bubble burst surfaced on January 27, 2025 when the effectiveness of DeepSeek’s AI reasoning model demonstrated that Nvidia could be overvalued, causing a sharp price drop on the day and a big reaction in the S&P 500.² The ability to build AI models at lower cost and the presence of AI leaders outside the US has profound implications for investors narrowly focused on US Big Tech dominance.

The Magnificent 7 stocks (Apple, NVIDIA, Microsoft, Amazon, Meta, Alphabet, and Tesla) are closely related in terms of their activity and characteristics. Having come down from its December 2024 peak, the weight of these stocks in the S&P 500 was still elevated at 29.5% as of April 17, 2025 (Figure 3). When market trends change, however, these stocks tend to move together, making the S&P 500 vulnerable. The Magnificent 7 have accounted for 413 points of the price index’s 599-point fall year to date.³

Fear of Geopolitical Escalation

Tariffs are dominating discussions, but there are several geopolitical tensions which could lead the headlines again. The nature of the end of the Russia-Ukraine war is one of these, with crucial importance for the transatlantic relationship, as well as relations with Russia. The suggestions earlier this year that Europe may need to step up its defense capability as the US military withdraws support has had a profound impact. The announcement of big spending plans and a loosening of fiscal policy in the EU and Germany, which should boost the European economy, resulted in a major change in market direction.

For now, equity markets do not appear to be paying much attention to the fate of other current conflicts including that between Hamas and Israel and its potential to spread further with an impact on trade and commodities markets. Meanwhile, tense trade negotiations are causing a further rift between the US and China, with the possibility of Chinese action on Taiwan not ruled out.

How Markets and Investors Have Been Responding

There has been an elevated reaction ever since election day – both on the upside and downside. To understand the financial market response to Trump’s trade proposals and the rise of uncertainty, we review performances of US and European equity sectors, and their ETF flows.

US and European Sector Performances 2025 Year to Date

The darlings of previous years, the US IT and Consumer Discretionary sectors have weakened the most so far this year on concerns of overvaluation during a period when earnings outlooks no longer look as superior (Figure 4). The Magnificent 7 stocks have led this underperformance, as detailed above, resulting in a negative performance for the S&P 500 while defensive sectors outperformed.

European sectors have proven more resilient. Leading sectors include defensives Utilities and Consumer Staples as well as cyclicals Financials, Industrials, and Communication Services (courtesy of its large telecoms component). It is worthy to note:

• European Industrials has outperformed mainly because of the 25% weight to Aerospace & Defense stocks, as of April 17, 2025. As the US indicated that it intends withdraw military support from Europe, the EU and European governments (most notably Germany, but also including the UK) have committed to more defense spending to support Ukraine as well as to protect the region long term. Germany’s government also approved the removal of the debt brake, allowing extra spending on wider infrastructure plans and for building data centers driven by AI demand. This could provide tailwinds for construction and machinery companies within Industrials.
• European Financials has been buoyed by hopes of merger and acquisition activity amongst the banks, which is necessary to build larger scale operations to invest in new technology. There is also benefit in upgrades to the economic outlook and stock market strength. The sector’s extreme discount to the broader market and attractive dividends have appealed to investors, alongside structural growth in insurance, exchange, and asset management businesses.

Investor Sentiment Reflected in ETF Flows

So far this year, there have been record flows into equity ETFs. But ETF investors have shifted their approach and rapidly increased their exposure to European equities, and there has been a marked slowdown in flows into US equities, as well as a pick-up in flows to gold and money market ETFs. This was driven by a more bullish outlook on European economic growth, as supported by fiscal spending and the large gap relative to US valuations.

Trends in sector ETFs since Trump’s election show an immediate uplift in US Financials inflows, amid investors’ hopes for deregulation and tax cuts like those seen during Trump’s first administration (Figure 5). The US Technology sector’s size and demand for AI ensured inflows when the equity market was rising, but flows waned as the sector underperformed especially after the DeepSeek news.

There was a change in investor behavior as the S&P 500 fell and volatility started to increase and tariff fears rose in the second half of the first quarter. US Technology and US Financials saw a reversal in the direction of ETF flows and some rotation into US defensive sectors such as Utilities and Consumer Staples. Simultaneously, there was a shift to some European sectors, including Industrials on the military defense story and Financials on hopes of a stronger domestic economy.

The question from here is, where should investors look to diversify next? How can you adapt portfolios to position for rapidly evolving US policies?

Strategies for Managing Volatility: Diversify Investment Approaches

For diversification purposes, we encourage investors to look to low volatility or low correlated sectors as well as to regional exposures through broad-based indices.

Constructing Sector Barbell Strategies

For the many investors who are overweight US Technology but retain long-term conviction in its outlook, pairing it with another sector could enable them to stay invested while adding potential diversification benefits to their portfolio.

A barbell strategy is a two-asset, equal weight basket comprised of a target asset — in this case, US tech — and a second asset that plays the role of diversifier, as determined by historical risk and return analysis. For the purposes of analysis, we use annualized volatility as our risk measure.

Our analysis finds that after US Tech’s recent underperformance, several sector barbell combinations have outperformed US Technology as a single investment over shorter time horizons and with much lower volatility (Figure 6).

Historical Risk and Return Analysis

Investors in US Technology should be aware of the significant increase in volatility recently observed. Figures 7 and 8 show the values of the realized returns and volatilities, and these are combined in Figure 6 to show realized return plotted against volatility over different investment horizons.

Broadening out to consider European sectors, we highlight a barbell pair of US Tech with European Industrials and European Financials, both of which have been attracting recent investor attention. We observe that over horizons up to three years, these barbells outperform US IT alone (Figure 6).

Notably, defensive barbells have also protected on the downside in 2025 year to date. This can be observed as the barbells shift left and up for shorter time horizons compared with US Tech on its own, demonstrating more effective diversification (Figure 6).

We observe high volatility of US Tech in every period (Figure 8). However, when paired with the selected sectors, volatility is significantly reduced — showing improved risk-adjusted returns (return divided by volatility) for periods up to five years, with a small sacrifice for the 10-year period.

This diversification benefit is even larger when correlations are lower. Note that correlations for all pairs have reduced sharply in the past year (Figure 9). However, the recent uptick is typical during extreme market moves when securities tend to move in the same direction. For the correlation calculation, we did not take the different time zones into account.

Barbell Approaches to Broad Indices

An investment in the S&P 500 gives investors close to 30% exposure to just one sector as of April 17, 2025 — technology (Figure 10). The S&P 500 is highly concentrated, with an effective number of shares of just 58 (the lower the number, the more concentrated it is). Investors may want to consider adding regional diversity via a barbell approach given that current volatility is expected to persist.

S&P 500 with MSCI Europe

Combining the S&P 500 with MSCI Europe reduces exposure to the US and US Technology, simultaneously increasing exposure to European Financials and Industrials — important for investors seeking exposure to the European domestic economy (Figure 10).

Figure 11 shows the very different patterns of risk and return between the two indices and the impacts of combining them over different time periods.

MSCI ACWI and FTSE RAFI 3000

As a final illustration, we combine the market-cap weighted MSCI ACWI index with the broad fundamentally weighted FTSE RAFI All World 3000 Index. As of April 17, 2025, the FTSE RAFI had 51% US exposure, 12% less than the MSCI ACWI — and a much-reduced exposure to US Tech at only 6%. The high number of effective shares, 524, demonstrates the FTSE RAFI’s lower level of concentration. The FTSE RAFI also displays a much lower P/E ratio at 15.5 compared with the MSCI ACWI at 21.7 (Figure 10).

Historical Risk and Return Analysis

As we did for the sector barbells, we show historical risk and return for the last 10 years. Broad index barbells, like sector barbells, may help reduce volatility over various time horizons. This is worthy of consideration given current uncertainty.

The correlation between the MSCI ACWI and the FSTE RAFI 3000 remains relatively high (Figure 14), which is unsurprising given their similar regional exposures. However, over time, it did come down from near 100% to 85% because of the increased difference in US Tech exposure. Ten years ago, the MSCI ACWI had 5% and the FTSE RAFI 3000 had 3.5%.

Since the correlation between the S&P 500 and the MSCI Europe is much lower (based on daily returns, we did not take into account the different time zones), the diversification benefit is strong, with barbell volatility less than the average of the two volatilities (Figure 13).

Just as we saw for the sectors, a recent uptick in correlation can be seen due to the strong market move where the individual securities move in the same direction.

Diversification Is Greater Than Concentration

Even as the immediate shock of Liberation Day abates and US policy ambitions become clearer, there are still many unanswered questions. We believe heightened uncertainty and US stock market volatility is likely to persist for some time, especially given current geopolitical concerns, US Tech concentration risk, and potential US economic weakness.

Despite US policy uncertainty and investors’ growing confidence in Europe, the US still offers potential investment opportunity and US Technology is still a systemic growth sector. Given it can be challenging to drop much-loved assets like the S&P 500 and US Tech, a measured way to potentially reduce risk is to reduce their allocations and broaden out via barbell strategies. As shown in our analysis, a relatively low correlation between US Tech and several other sectors can help deliver potential diversification and risk mitigation benefits to portfolios, and a similar story can be seen regionally.

With contributions from Hugo Amiel, ETF Strategy & Research intern analyst.