A Change on the Leader Board

Breaking a long streak of U.S. stock market performance exceptionalism, the month of February has seen non-U.S. markets dominating the leader board. Both the MSCI Developed Market ex-U.S. and Emerging Market benchmarks are well ahead of the S&P 500 for the month and year-to-date. The European blue-chip index, the Euro Stoxx 50, has finally breached its all-time high hit back in the spring of 2000, and the Stoxx 600 Index has gained nearly 10% this year, outpacing the S&P 500’s gain of roughly 4%. In what some have considered the ideal trifecta of rising investor sentiment, attractive relative valuation and underweighted investor positioning, the stage was set for the performance tailwind we see today. Adding to the mix, we have the European Central Bank and the People’s Bank of China set to continue their stimulus.

However, there are risks on the horizon: Both Europe and China are in the crosshairs of the changes in trade policy espoused by the new U.S. administration, and Europe faces an even more difficult fiscal future with the U.S. now forcing Europe to increase defense spending after a lengthy period of disarmament following the fall of the Berlin Wall. Defense spending is currently running at 2% of GDP for Europe (unevenly), though NATO has indicated the current spending target of 2% may need to be raised to 3.6% — a massive increase. This will require European countries to run higher fiscal deficits to finance the additional spending. It may also require deeper pan-European cooperation.

This weekend will be important as the looming German election may usher in changes to the government debt limit. Current polling seems to favor a coalition government, with neither the center-right Christian Democrats (CDU/CSU) nor the further-right Alternative for Germany (AfD) parties gaining enough votes to govern alone. A major agenda item will be potential reform of Germany’s “debt brake,” which is a fiscal rule that limits government borrowing by constraining the budget deficit to 0.35% of GDP. In addition to the upward pressure on defense spending, Germany in particular has suffered economically and sits on the brink of recession while still experiencing inflationary pressures, now driven by energy prices. We will be watching the outcome carefully. Importantly, these issues and risks are well known and, in isolation or in aggregate, may have caused investors to avoid exposure. That would have been a mistake: The German DAX benchmark has gained over 10% year-to-date, and has risen over 30% year-over-year — besting the S&P 500 over each time period.

Walmart (WMT), the largest U.S. retailer, surprised Wall Street this week with a relatively cautious forecast for 2025. Despite its strong Q4 results, Walmart’s forward guidance is what caught investors’ attention, sending the stock down over 8% as of this morning from its recent record high. Noting the uncertainty of tariffs, Walmart’s CFO struck a more cautious tone, but emphasized the company’s history of working closely with suppliers and the fact that the company sources two-thirds of its annual spend for products made, grown or assembled in the U.S. The company also suggested that the implementation of broad-based tariffs would risk reversing the progress made thus far on the inflation front.

Consumers, and lower decile income households in particular, could be vulnerable. Interestingly, higher prices are causing wealthier households to “trade down” and explore aisles of Walmart that had not previously been on their radars. We have seen this kind of behavior during the peaking of consumer price inflation in the summer of 2022. Importantly, however, many companies appear to be preparing to pass on tariff-related price increases, with indications explicit in many of the quarterly earnings call transcripts. This remains a key risk to our base-case outlook for inflation to continue to drift toward the 2% Federal Reserve target over the next year or so, and the concern is that the immediate inflationary impact of tariffs will undermine that premise. While the tariff news continues to be very fluid and fast moving, we are not changing our base case at this time.

U.S. interest rates have fallen from the mid-January 2025 highs. Despite the inflationary threats of tariffs and the general sense of political uncertainty, the 10-year U.S. Treasury yield has fallen from roughly 4.80% to 4.45% today, and the 2-year Treasury yield has fallen from 4.40% to 4.25%. The current 10-year yield sits comfortably inside our projected 12-month range of 4.10% to 4.60%. Our forecasted range is informed by the assumption that the longer end of the yield curve may be more anchored above 4%, reflecting continued policy uncertainty, the potential for continued heavy issuance of U.S. Treasuries required to fund the U.S. debt, and fiscal deficits. At the same time, our fixed-income team sees shorter duration rates falling, with its forecast for the 2-year Treasury yield of 3.50% to 4.00%. This reflects a view that the market may be underestimating the willingness and ability of the Fed to cut policy rates this year.

We still see the potential for two to three rate cuts this year, and we believe that, while the Fed may be sensitive to the short-term one-time inflationary impact of tariff policy, the threat this brings to the growth outlook may take precedence.

It is hard to believe we are at the five-year anniversary of the beginning of the COVID-led bear market: Within the span of just a month, the S&P 500 fell 35%, market volatility as measured by the VIX index spiked from 14 to over 80, and high-yield credit spreads — the additional return investors require to own lower-quality bonds over Treasury securities — widened from 3.62% to nearly 11%. These were difficult times in so many ways, and the fear and uncertainty associated with the global pandemic was quickly reflected in asset prices. We are now well past the COVID crisis, although we have managed through a period of higher-than-expected inflation coupled with persistently higher interest rates. Today, the S&P 500 is flirting with record highs, market volatility is barely above its pre-COVID lows, and high-yield spreads are near record tight levels. Clearly, being a long-term investor and sticking with your investment plan through periods of acute and intense uncertainty has been the optimal strategy.

But what now? Record highs? Record tights? Many investors climb that proverbial wall of worry only to get skittish as markets rise, fearing they will buy risk assets at the peak and face the consequences of the “inevitable” drawdown. Our research suggests that, even at market tops, investors should focus on building and maintaining their strategic allocations to risk assets, even adding to positions with cash if that is required to reach desired allocations. Short-term returns are notoriously unpredictable, but in looking at longer time horizons we find that future 1- and 5-year returns are about the same or even slightly higher when investing at all-time highs than on any other day. For investors, the message is a tale as old as time:  get invested — and stay invested — to reap the benefits of equity exposure.

Sources: Northern Trust Research, Bloomberg. Daily S&P 500 prices from January 1950 through May 2024 are used to determine all-time highs. Future 1-year and 5-year returns are annualized total returns based on daily S&P 500 total return data over the period.