The Great Diversification: Investors Rotate Out of US Stocks

Khan Capital | May 2025

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Key Takeaways

• Investors are rotating out of US equities at a pace not seen in years, driven by a US forward P/E premium of approximately 50% over international developed markets, dollar weakness of roughly 10%, and the repricing of US-specific tariff risk.
• European equities are the primary beneficiary, powered by Germany’s historic €500+ billion fiscal stimulus, improved bank profitability, and defence spending commitments that create a multi-year earnings growth story.
• Dollar weakness provides a double benefit for US investors in international equities: price appreciation plus currency gains, making unhedged international exposure particularly attractive in the current environment.
• Within the US, the broadening of earnings growth beyond the Magnificent Seven creates an opportunity in the “S&P 493,” which trades at approximately 18 times forward earnings, a significant discount to the index-level multiple.
• The rotation is structural rather than tactical: the combination of extreme valuation differentials, policy divergence, and institutional recognition of single-country concentration risk suggests the great diversification has further to run.

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Something remarkable is happening in global capital flows: investors are rotating out of US equities at a pace not seen since the post-financial-crisis era. International developed markets are outperforming the United States. European equities, powered by Germany’s historic fiscal stimulus and improving economic data, have delivered double-digit returns year-to-date while the S&P 500 struggles to reclaim its February highs in the aftermath of the Liberation Day tariff shock. Japanese equities, buoyed by corporate governance reform and a weak yen, continue to attract record foreign capital. Even emerging markets, long shunned as the dollar surged, are finding a bid as the greenback weakens and commodity prices stabilise. After years of US exceptionalism that made geographic diversification feel like a performance drag, the great diversification trade has begun.

The Catalysts: Why Now?

The rotation away from US equity concentration is being driven by a convergence of forces that, individually, have been building for years but are now arriving simultaneously.

The valuation gap has reached unsustainable extremes. US equities entered 2025 trading at a forward P/E premium of approximately 50% relative to international developed markets, the widest differential in at least two decades. The S&P 500’s Shiller CAPE ratio exceeded 37, while the Euro Stoxx 50 traded below 15 times forward earnings. The arithmetic of mean reversion is powerful: US earnings growth would need to outperform international earnings growth by an historically improbable margin for the current premium to be sustained, let alone expanded.

The tariff shock created a US-specific headwind. The Liberation Day tariffs of 2 April and the preceding tariff escalations on Mexico, Canada, and China imposed costs that fall disproportionately on US companies and US consumers. The S&P 500’s 15% drawdown from February to April was partly a repricing of the tariff risk that had been dismissed during the post-election rally. International equities, while not immune to global trade disruption, were less directly affected by tariffs that were primarily designed to penalise US import activity.

The dollar is weakening. The US Dollar Index has fallen approximately 10% from its 2024 highs. The combination of Fed rate cuts, rising fiscal deficits, and the erosion of confidence in US economic policy (driven by tariff uncertainty, threats to Fed independence, and the government shutdown) has weighed on the currency. Dollar weakness is a powerful tailwind for international equity returns: when a US investor owns European or Japanese stocks, a falling dollar enhances the return in dollar terms, creating a double benefit from both price appreciation and currency gains.

Europe has a genuine growth story for the first time in years. Germany’s announcement of a fiscal stimulus package exceeding €500 billion, encompassing defence spending, infrastructure investment, and a relaxation of its constitutionally mandated debt brake, represents the most significant shift in European fiscal policy since the creation of the eurozone. The combination of fiscal expansion, ECB rate cuts that brought borrowing costs down throughout 2024, and a more competitive euro is creating an environment in which European corporate earnings can grow at rates that have been reserved for the United States in recent years.

What the Market Is Misunderstanding

This is not a tactical trade; it is a structural reallocation. The rotation out of US equities is not driven by a single catalyst that will reverse when headlines change. It is driven by the combination of extreme valuation differentials, a weakening dollar, fiscal expansion in Europe, and a growing recognition among institutional allocators that concentrating 70% of a global equity portfolio in one country (as passive global indices effectively require) creates unacceptable single-country risk. The rebalancing has been building for years and has further to run.

US exceptionalism is not dead; it is being repriced. The US remains the dominant economy in technology, AI, and innovation. US corporate earnings growth has consistently outperformed international peers for over a decade. The issue is not whether US companies are better than international ones but whether the premium investors pay for that superiority has become so extreme that future returns are mathematically constrained. A P/E premium of 50% implies a degree of perpetual outperformance that history suggests is unsustainable.

The Magnificent Seven drag is creating an opportunity in the rest of the S&P 500. The same concentration risk that is driving investors overseas is also creating a domestic opportunity: the “S&P 493” (the S&P 500 excluding the Magnificent Seven) trades at approximately 18 times forward earnings, a far more reasonable valuation. The broadening of earnings growth beyond mega-cap tech, with non-tech S&P 500 earnings growing approximately 10% year-over-year, creates the foundation for a domestic rotation from growth to value, from mega-cap to mid-cap, and from technology to industrials, financials, and healthcare.

Where the Flows Are Going

European equities are the primary beneficiary. The combination of fiscal expansion, improved bank profitability (driven by higher rates and deregulation tailwinds), and defence spending commitments creates a multi-year earnings growth story. European financials and industrials offer the most direct exposure to these themes. The STOXX 600’s discount to the S&P 500 on a sector-adjusted basis remains near its widest point, suggesting further room for convergence.

Japanese equities continue to benefit from the Tokyo Stock Exchange’s corporate governance reforms, which have pressured companies to unwind cross-shareholdings, increase shareholder returns, and improve capital efficiency. The weak yen enhances the competitiveness of Japanese exporters and the dollar-denominated returns for foreign investors. Warren Buffett’s high-profile investments in Japanese trading companies have provided a seal of approval that has encouraged institutional flows.

Select emerging markets are attracting capital on a differentiated basis. Commodity-exporting economies (Brazil, Middle East, parts of Africa) benefit from elevated commodity prices and improved terms of trade. India’s growth story, driven by demographics, digital transformation, and manufacturing buildout, continues to attract structural inflows despite elevated valuations. China remains more complex: Beijing’s stimulus measures have provided tactical rallies, but the structural challenges in the property sector and the geopolitical overhang of US-China tensions create a higher bar for sustained allocation.

Implications for Investors

Rebalance geographic exposure. The decade-long overweight to US equities that passive global index tracking has created is a source of concentration risk that the 2025 tariff shock exposed. A deliberate rebalancing toward international developed and emerging markets, even at the margin, improves diversification and positions portfolios to capture the valuation convergence that is now underway.

Currency exposure is a feature, not a bug. Dollar weakness enhances international equity returns for US-based investors. Rather than hedging FX exposure (which removes the currency tailwind), consider leaving international equity positions unhedged during a period of dollar depreciation.

Favour European financials and industrials. These sectors offer direct exposure to the fiscal expansion and defence spending themes at valuations that remain depressed relative to US peers. Banking consolidation (both cross-border M&A and domestic rationalisation) provides an additional catalyst.

Domestically, the broadening trade is the opportunity. Within the US, the rotation from mega-cap growth to the broader market, from the S&P 500 to the equal-weight index, and from technology to financials, industrials, and healthcare, offers diversification benefits without leaving the US market entirely.

Conclusion

The great diversification is not a contrarian call; it is the recognition that a decade of US equity dominance has created positioning extremes and valuation differentials that are now correcting. The combination of dollar weakness, European fiscal expansion, Japanese governance reform, and the repricing of US tariff risk is creating the most compelling environment for international equity allocation since the early 2010s. For investors who have spent years explaining why diversification “didn’t work,” 2025 is providing the answer: it works precisely when it is most needed, which is precisely when it has been most neglected.

Related Reading

The diversification trend was partly driven by the concentration concerns covered in Market Concentration Risk: Top 10 S&P 500 Stocks at Record 38%. For the tariff-driven disruption to US markets, see Liberation Day Tariffs. The Pfizer vaccine announcement that repriced the end of the pandemic is covered in Vaccine Day.

Related Reading: see Tesla Q1 2026 earnings reckoning. For continuing coverage on this theme, see our analysis of Wall Street’s Volatility Dividend: Q1 2026 Bank Earnings Deliver Record Capital Markets Quarter. For the fundamentals, start with the P/E ratio, explained.