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Broad Equity Compass

Broad Equity Compass – Regions in Focus

Senior Equity ETF Strategist

US Equities: Leadership amid the divergence

US equities have reasserted their leadership, rebounding strongly after weathering the tariff-induced storm earlier in the year. This renewed momentum is evident across performance, earnings, flows, and the broader economy. We believe an overweight in US equities relative to other developed markets is merited. We also see value in adding risk within US equities through small and mid cap exposures, which is appropriate for the balanced economic environment the US currently offers.

The US macro and market mix increasingly supports risky assets

The trade deficit-driven 0.5% contraction in Q1 has already unwound with a stellar 3.8% rebound in Q2.1 Trade-related uncertainty has faded, and the Federal Reserve (Fed) has begun long-awaited interest rate cuts. Fiscally, the One, Big, Beautiful Bill Act and ongoing deregulation are likely to bolster consumption and private investments. State Street Investment Management economists forecast 1.8% growth in 2025 and then a reacceleration to 2.3% in 2026. The recent performance broadening into riskier parts of US equities has a solid foundation to continue in the absence of negative shocks to inflation and growth.

And US small and mid caps offer a more targeted way to capitalize on the return of US exceptionalism compared to large caps. Companies in the Russell 2000, S&P Mid Cap 400, or MSCI Small Cap Value Weighted indices generate on average between 75% to 83% of their revenue domestically.2This US bias also aligns well with the Trump administration’s policies, which aim to benefit domestic consumers and drive private investments through incremental reshoring. Fading tariff uncertainty and resumption of Fed rate cuts allowed small caps to outperform the S&P 500 in Q3.

Figure 1: Equity performance by segment

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The appeal of small- and mid-cap companies

Small caps currently trade at relatively undemanding P/E multiples relative to large caps, allowing exposure to the robust US economy at a reasonable price. The earnings growth has been much more modest recently, but the rebound of US growth combined with rate cuts may lead to a long-awaited broadening of profit growth across small and mid caps in the coming quarters. We acknowledge that earnings growth is essential for a sustained rally.

Figure 2: Price to earnings multiples using FY1 estimates (excl. negative earnings)

Ways to invest in small and mid caps

US small- and mid-cap indices are cyclical and overweight Financials, Industrials, Real Estate, and Materials. But there are notable differences across indices:

  • The Russell 2000 Index is arguably the most unconstrained way to access small caps. Biotech and Software companies play a significant role—hence the proportion of companies with negative earnings is substantial. On the other hand, the unconstrained nature of the index enables exposure to risk-on moves, as observed in Q3.
  • The MSCI USA Small Cap Value Weighted Index emphasises small-cap companies trading at affordable multiples and is skewed toward Financials, a sector benefitting from deregulation and yield curve steepening.
  • The S&P Mid Cap 400 Index overweights Industrials companies which are likely to benefit from an expected increase in private investments and incremental reshoring. Constituents tend to be of relatively high quality compared to small-cap exposures, due to size and the S&P profitability requirements.
     

Figure 3: Sector composition

Small and mid caps are well-suited for an economic soft-landing scenario, where inflation is kept in check and growth remains robust. If the labour market deteriorates significantly or the US growth expectations decline, the large-cap S&P 500 Index may be the least impacted. It could even benefit, due to its reliance on technology and tech-adjacent sectors, which demonstrate a degree of yield sensitivity. Both the AI capex cycle and earnings show robust growth and resilience against macroeconomic uncertainty.

Investors can access small- and mid-cap exposure with these ETFs:

Investors can access US large caps via one of the share classes of the SPDR S&P 500 UCITS ETF:

Emerging markets: Growth engines in the great divergence

The MSCI Emerging Markets Index delivered a 27.5% return in the first three quarters of 2025, outperforming developed equities by 10.1% after US dollar weakening, China strengthening, and a rally in Korean and Taiwanese technology stocks. We remain constructive on emerging market (EM) equities given AI developments in China, fading trade uncertainty, a weak US dollar, and the ongoing growth advantage of underlying economies.
EM equities offer a rare combination of earnings-per-share growth and undemanding valuations. Given the sheer long-term catch-up potential, the upside appears to be immense. However, the propensity of the Chinese government to control the technology sector, while less likely to reemerge in current conditions, requires vigilant monitoring.
 

Figure 4: Emerging vs. developed market performance

Emerging Southeast Asia is best positioned, after the US, to benefit from the AI (r)evolution given the wealth of advanced companies in China, Taiwan, and South Korea. Taiwan and South Korea have long been indispensable parts of the global semiconductor supply chain, but the tech revival in China is a relatively new and potentially powerful phenomenon.

The revelation of the DeepSeek AI model reshaped the Chinese government’s stance on AI regulation, as the government needs to rely on the private sector to challenge US dominance in the AI race. This created a massive rebound of Chinese tech giants, which had previously been hampered by regulatory scrutiny. In Q3 Alibaba increased its AI budget to over $50B USD, reflecting both the commitment and strategic approach of Chinese companies to the AI theme. Companies in Southeast Asia and those linked to AI have been visible contributors to performance in 2025.

Figure 5: Some South Asian companies have a larger weighting in EM indexes than countries

Some South Asian companies have a larger weighting in EM indexes than countries

Investors may favour emerging markets because of their economic growth advantage over developed economies. EM countries, particularly in Southeast Asia continue to expand faster than the Eurozone, the UK, or Japan. China’s growth is slowing in absolute terms—but it is still expected to deliver higher GDP growth than developed economies including the US. India has taken the baton as the new growth leader.

Figure 6: Consensus economic growth forecasts

Emerging markets offer growth at a reasonable price. Strong performance and upbeat long-term growth expectations have led to some multiple expansion of EM equities which now trade at 13.7x 1y forward P/E. But the MSCI Emerging Market Index remains attractive compared to the MSCI World Index, which trades at a hefty 20.4x 1y forward P/E. Earnings growth is expected to strengthen over the next three years. We believe AI tailwinds, a weaker US dollar, and emerging markets’ economic growth advantage will help.

Figure 7: Valuation and earnings growth

EM equities indices are concentrated around Asia which represents approximately 80% of cap-weighted indices. As such China, India, Taiwan, and South Korea are key markets to monitor. EMEA and LATAM components provide a commodity cushion, offering a degree of diversification. Investors may consider complementing the MSCI Emerging Market Index exposure with the MSCI Emerging Markets Small Cap Index, as the latter overweights India and underweights China, making it a potentially valuable complementary exposure.

Figure 8: EM country composition

How can investors play emerging market equities?

European small caps: Policy tailwinds, tariff insulation

Fortunes in equity markets appeared to shift in favour of Europe early in the year as peace in Ukraine seemed more likely, Germany introduced a €500B massive fiscal plan, and European NATO members pledged increased investments while the US faced stagflation concerns. In response, European stocks outperformed while the euro, Swiss franc, and pound sterling all appreciated against the US dollar. As a result, ETF investors in Europe poured $37B USD in net inflows into European equities in the first half of the year, while institutional investors globally closed their underweight positions.3

The trend stalled as tariffs became a headwind for export-dependent large-cap European stocks, the peace process in Ukraine failed, and Europe again lagged the US in terms of growth. Since April, investors have been reluctant to increase their allocation to Europe and performance has stagnated. At least increased infrastructure spending, rearmament, and favourable monetary conditions remain intact.

Investors may find attractive pockets within European equities, but they need to be selective in choosing exposures that play to fiscal and monetary tailwinds and provide insulation against tariff- and currency-related headwinds.

We favour European small caps. Companies within the MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index are relatively domestic—each generating 66% of revenue within Europe and only 11% and 12%, respectively, in the US. The MSCI Europe Index derives only 46% from Europe and as much as 23% from the US.4

Small caps’ domestic profile potentially provides a degree of tariff insulation, makes strong currencies less of a headwind, and offers exposure to expected fiscal spending related to infrastructure. Small caps are also rate-sensitive and could benefit from the long-awaited lower rate environment.

European small caps offer a compelling combination of value and growth relative to large caps. The MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index trade at a 6% and 1% discount, respectively, to their 10y average P/E levels while the MSCI Europe Index trades at a 6% premium. And the expected earnings growth of the MSCI Europe Small Cap Index stands at 11% versus just 2% for the MSCI Europe Index.5

Figure10: Price-to-earnings using FY1 estimates (excluding negative earnings)

Contributor and author:

Krzysztof Janiga profile picture
Senior Equity ETF Strategist

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