A commonly heard quip of economists throughout the post-war era has been, “When America sneezes, the rest of the world catches cold.” This refrain also applied to the 2008 financial crisis and the COVID-19 pandemic, when the U.S. economy and stock market far outperformed its international peers (see chart below). This adage, however, does not apply to the current trade war.
During the first 16 weeks of this year, the U.S. stock market underperformed international markets by the widest margin since 1993, according to the Financial Times. The MSCI USA index lost 11%, while the MSCI international index rose 4% in dollar terms. An 8% weakening of the dollar against a basket of six key currencies including the euro and yen was a contributing factor.
U.S. Vs. International Equities
The U.S. stock market’s underperformance is widely attributed to investors’ expectations that President Donald Trump’s tariff blitz will contribute both to a slowing of the U.S. economy and to higher U.S. prices. This reflects a sea-change in expectations from the start of this year, when investors anticipated that the U.S. economy would be bolstered by tax cuts and deregulation.
The shift in expectations is apparent in the IMF World Economic Outlook published last month. The IMF’s projections now call for U.S. real GDP growth to slow from 2.8% in 2024 to 1.8% this year, down from 2.2% in the prior forecast in October.
The IMF’s projected slowdown for the U.S. is the largest for any advanced economy, and it is expected to be accompanied by a surge in U.S. inflation to 3% — a full percentage-point increase from the January forecast. If so, this outcome would indicate that the massive tariffs Trump is contemplating would inflict greater damage on the U.S. economy than on other industrial economies.
This begs the issue of whether the U.S. economy might prove resilient to tariff increases, just as it did to Federal Reserve rate hikes in 2022 and 2023.
First quarter GDP results released by the Bureau of Economic Analysis showed how the economy fared just before Trump’s “Liberation Day” announcement on April 2. During the quarter, real GDP contracted at a 0.3% annual rate, which heavily influenced by the response of U.S. businesses to pending tariff hikes.
The main factor contributing to the decline in real GDP was a surge in imports of 41% at an annual rate, as businesses built up inventories in anticipation of higher import prices due to tariffs. By comparison, exports rose at only a 1.8% rate.
The steep plunge in consumer confidence readings this year was accompanied by a slowing in consumer spending to a 1.8% annual rate from 4% in the fourth quarter of last year. However, business fixed investment surged at a 22.5% rate, as companies appeared to be front-running tariffs, according to the Wall Street Journal. Overall, domestic demand rose at a 3% annual rate.
The full brunt of the tariff hikes is likely to be felt in the next two to three quarters, as supply-chain shortages take hold. The longer the trade war persists, the greater is the risk that a recession could unfold at some point, which is not yet reflected in stock prices.
Meanwhile, the U.S. stock market has stabilized following Trump’s announcement on April 9 that reciprocal tariffs would be suspended for 90 days for U.S. trading partners. The principal exception is China, where the U.S. boosted its tariff rate on that country’s goods to 145% in response to Chinese retaliatory tariffs.
Looking ahead, the case for international markets to outperform the U.S. market hinges on three considerations.
One is that international equity markets, and especially European markets, are considerably cheaper than the U.S. stock market even after taking into account the greater weight in technology stocks in the U.S. For example, the average P/E ratio for international stocks over the past decade was more than 20% lower than the U.S. average, noted in a recent post on Forbes.com. By comparison, the current discount for European equities is more than 35%, according to Bloomberg.
Second, Trump’s stance on national security issues and on tariffs has been a catalyst for European countries to boost defense spending and to undertake other initiatives to bolster their economies. Germany’s stock market received a boost when newly elected Chancellor Friedrich Merz won lawmakers’ approval in March for an ambitious plan to loosen the nation’s strict debt rules for higher defense spending and to set up a large fund to finance public infrastructure, Reuters reported. The stock markets for Germany, Poland and Spain, in turn, have posted double-digit returns so far this year.
Third, the backlash to Trump’s tariffs and national security stance has also resulted in a marked decline in the dollar this year, even though interest rate differentials have widened in favor of the dollar. This has raised the specter that there could be crisis of confidence in the dollar at some point, as I have discussed previously. Meanwhile, the status of the U.S. as a safe haven is being questioned.
Finally, in the event the trade war leads to a rupture in global trade patterns, equity market correlations could decline after they rose steadily during the era of globalization. If so, investing in international equities should provide greater diversification benefits than was evident in the past 25 years.