Position Toward Quality Stocks and Policy Tailwinds
Structuring equity portfolios to withstand macroeconomic uncertainty means rethinking geographic diversification, focusing on quality stocks, and positioning for secular tailwinds from broadening AI adoption and greater defense spending.
Market optimism on US assets was high at the start of the year, buoyed by AI momentum and expectations for tax cuts and deregulation after the election.
But weakening consumer sentiment amid tariff uncertainty, new AI competition from China, and progress on European fiscal reform have challenged US exceptionalism. In fact, non-US equities have outperformed US equities year to date.
Progress in trade negotiations, resilient hard economic data, and solid Q1 earnings results have supported a strong rebound in US equities since Liberation Day. And US Tech leaders remain in advantageous positions. But the Trump administration’s unprecedented efforts to reset the global trading paradigm have disrupted global capital flows.
And that has investors rethinking the geographic diversification of their portfolios, especially given stretched valuations of US equities after the recent rebound.
Yet the Trump administration’s fiscal policy priorities — deregulation, tax cuts, and increased defense spending — may offset some of the damage to US sentiment caused by tariffs and potentially create new investment opportunities in the US.
To navigate heightened economic uncertainty and the rewiring of global trade, investors should consider:
- Choosing multi-factor strategies that combine Quality, Value, and Minimum Volatility for US and non-US exposures, aiming to capture potential upside with a defensive bias.
- Positioning portfolios toward secular tailwinds from broadening AI adoption and increasing defense spending.
Move up in Quality Amid Uncertainty in the US
The US outlook is a tale of dueling data. Hard economic data, like personal consumption and payroll growth, have generally held up. But consumer and business sentiment has been sour due to trade uncertainty (Figure 1).
Q1 earnings mirrored the trend, as double-digit growth and above-average earnings surprises came with more negative guidance and a large downward revision on full-year S&P 500® earnings per share (EPS). This suggested a solid economy and healthy corporate profits heading into the tariff shock on April 2. But higher tariffs and elevated trade policy uncertainty have created greater downside risks to growth and profit margins than we expected at the beginning of the year.
While weak sentiment data doesn’t always lead to a slowdown, and though downward earnings revisions have lowered the bar for more positive surprises later on, positive outcomes are conditioned on further tariff reductions and trade resolutions.
It’s unlikely that tariffs will return to pre-Liberation Day levels — that’s creating inflationary pressure and reducing consumer purchasing power in the near term. While initial negotiations with some US trade partners have shown promise, headline-driven market volatility likely will continue until there is greater clarity on the magnitude and scope of tariffs.
Heightened trade policy uncertainty also has created a challenging backdrop for US monetary policy. The May Federal Market Open Committee (FOMC) statement noted the rising risks to both higher unemployment and higher inflation. Chairman Powell acknowledged that it’s too early to judge which side of the Fed’s dual mandate is at a greater risk from the impact of tariffs.
That’s why the phrase “wait and see” was mentioned 12 times during the May FOMC press conference, indicating the committee’s cautious approach in assessing hard and sentiment data before making policy adjustments. This backdrop gives the Fed less leeway for preemptive easing in response to weaker economic sentiment, lowering the strike price for the Fed put on stock markets.
On the other hand, the budget reconciliation process centered around tax cuts and higher defense spending is likely to be the next policy focus — and potentially provide fiscal support and improve the growth outlook. The House and Senate have passed an amended budget resolution1 for fiscal year 2025 in April that allows for up to a $5.7 trillion deficit increase over the next 10 years, including $3.8 trillion for extending the 2017 Tax Cuts and Jobs Act (TCJA) tax cut permanently and $1.5 trillion for new tax cuts.2
Several tax cut provisions have gained broad support in Congress, such as the extension of expiring provisions in the TCJA, expansion of the Child Tax Credit, and immediate expensing of research and development costs. If passed, these will drive fiscal expansion, supporting business and consumer sentiment in the second half of the year. Because the budget resolution included an expansion of the debt ceiling, it creates pressure on Republicans to pass the tax cut bill before the US hits its debt limit and potentially defaults on the August X-date.3
With a mix of macroeconomic tailwinds and headwinds in the US, a multi-factor strategy targeting high quality and low volatility companies with attractive valuations may help portfolios withstand macroeconomic uncertainty and enhance the core by potentially mitigating downside risk while capturing market upside.
Increase Geographic Diversification
Extreme US policy uncertainty and the Trump administration’s chaotic approach to reshaping global trade have weighed heavily on business sentiment and prompted investors to reassess the importance of geographic diversification in their portfolios.
As the US retreats from the global trade system and promotes self-reliance, other countries may have to forge new paths to growth, creating divergent economic policy and outcomes. Since we’re still in the early inning of deglobalization, it’s hard to predict winners and losers in this regime shift. But less synchronized economic cycles across economies likely will provide greater geographic diversification than over the past 15 years. A geographically diversified portfolio may help investors navigate this uncertainty.
The positive progress in German fiscal reform and strong international equity performance year to date showcase what investors can gain from geographic diversification. Germany passed a landmark constitutional amendment raising its deficit limit and increasing defense and infrastructure spending. The fiscal stimulus is large enough to materially lift the growth trajectory over the medium term but remain sustainable given significant saving rates in Germany.4 As a result, German equities have outperformed their US peers by 18% in local currency and 27% in USD terms year to date.5
In fact, 19 of 22 developed countries have outperformed US equities year to date. And ETF flows have followed. Inflows into international developed markets are outpacing US-focused ETF inflows relative to their beginning year asset base.6
It’s time for investors to reduce portfolio concentration in US equities by adding international equities given the exceptional outperformance of US equities over the past 15 years and the potential of performance mean reversion driven by the recent macroeconomic paradigm shift.
Despite weaker economic and earnings growth projections than the US, earnings sentiment outside the US has held up better (Figure 2) due to investors’ extremely pessimistic outlook following the US election. Indeed, valuations have picked up notably from depressed levels at the beginning of the year. But they are still trading at a 30% discount to the US, compared to an average of 14% discount over the past two decades.
More importantly, we expect most developed market central banks to continue easing in support of growth with less constraint than the Fed given the firmer disinflationary trend overseas. Larger-than-expected monetary easing may lift price multiples in international developed markets for the rest of 2025.
Acknowledging further economic uncertainty and downside risk driven by higher tariffs, we suggest investors take a defensive approach when increasing international exposure for diversification. Combining Quality, Low Volatility, and Value factors may help investors enhance the core international allocation by mitigating downside risks without sacrificing too much of the upside potential.
Position for Broadening AI Adoption
Despite economic uncertainty, we see continued strong momentum in AI demand and related capex investments. Strong cloud revenue growth, with increasing contribution from AI, dispelled market concerns about the return on investment (ROI) of Big Tech’s AI capex. Indeed, AI business use accelerated in 2024, with 78% of organizations reporting using AI, up from 55% the year before.7
Corporate IT leaders have shown a strong appetite for AI-enabled solutions. It’s projected that worldwide spending on technology to support AI strategies will more than double to $632 billion by 2028, with more than two-thirds of the spending coming from AI-enabled applications and platforms.8
And the desired timeline on adoption of AI-powered software applications has also become shorter as more high-performing, low-cost, and open-source models become available.9 Given better demand visibility, major hyperscalers’ AI capex is on track to increase more than 30% year over year in 2025.10
Supported by strong AI demand, Tech and Communication Services sectors have had strong earnings growth and their outlook continues to be positive. They were among the top three sectors of Q1 earnings growth, with 90% of companies beating earnings expectation. The two sectors together drove more than half of S&P 500 earnings growth in Q1 and are expected to continue as the key growth driver for the rest of 2025 (Figure 3).
Valuations of Tech-related leaders have become more attractive than they were one year ago. Forward price-to-earnings ratios of the NYSE Technology Index — an index composed of 35 leading US-listed technology-related companies across different sectors — are trading in the bottom tercile since the beginning of the pandemic and bottom quintile relative to the broad market, even though their operating margin is near record high.11 These underscore a quality growth opportunity with reasonable valuations.
Capture Increasing Defense Spending Policy Tailwinds
Higher defense spending has regained traction in Congress and the White House this year as global defense spending experienced the fastest growth since the end of the Cold War.12 The Senate budget reconciliation instruction includes a $150 billion increase in defense spending with a focus on shipbuilding, missile defense, and munitions. Those spending increases likely will make it to the final bill given the broad bipartisan support.
Meanwhile, seeking to achieve “peace through strength” in national security and foreign policy, the Trump administration has requested a $1 trillion national defense budget for fiscal year 2026, an increase of 13% from FY 2025. The recent announcement for a proposed Golden Dome missile system at a cost of $175 billion over three years13 underscores the administration’s ambition in advancing the defense system with state-of-the-art technology.
Given intensifying great power competition and near-record-low defense spending as a percentage of GDP in the US, we’re likely still in the early years of the new defense spending cycle. This creates a positive macro environment for the Aerospace and Defense industry.
During the last defense spending cycle between 2001 and 2011, the Aerospace & Defense industry posted stronger growth than the broad market for most years, including during two economic recessions.14 Its resilience supported by the secular trend led to 39% outperformance over the broad market on a cumulative basis.15
Similar growth trends are expected for 2025 amid higher demand and easing inflation. The industry’s consensus growth estimate for 2025 is expected to rebound from last year’s trough — nearly 10x that of the broad market (88% vs 9%).16
Despite the industry’s more than 10% outperformance year to date, its relative price-to-book ratio is still more than 10% below the long-term median and the median level during the last defense spending cycle, indicating potential for multiple expansions.17
Implementation Ideas
To defend against increasing economic uncertainty and the rewiring of global trade, equity investors should consider:
Systematic core equity strategies that combine low volatility, quality, and value factors.
Equal-weighted exposure to 35 US-listed tech-related leaders across Information Technology, Communication Services, and Consumer Discretionary.
A modified equal-weighted exposure focused on aerospace and defense industries.
