ETF Performance Broadens Beyond U.S. EquitiesETF Performance Broadens Beyond U.S. Equities
In February, we saw signs of reversal in sentiment around U.S. market outperformance relative to other regions.
The last two calendar years have been outstanding for U.S. equities, with a total return of 24.5% and 26.3% for the iShares Core S&P 500 ETF (IVV) in 2024 and 2023, respectively. It has been a tech-driven rally, with the “Magnificent 7” stocks accounting for 53% of the S&P 500’s total return in 2024. This investor enthusiasm around growth-oriented technology stocks was reinforced after President Donald Trump’s election in November 2024, with initial expectations of more M&A activity and less financial regulation.
However, in February, we saw some signs of reversal in sentiment around U.S. market outperformance relative to other regions. The 3% rise in the January CPI-all items index, released on Feb. 12, was higher than expected. Multiple executive orders on tariffs have reinforced these concerns of persistent inflation. Together, these developments have pushed out expected rate cuts by the U.S. Federal Reserve to late 2025.
Since the first tariff announcements on Feb. 1 (which were subsequently paused), non-U.S. equity ETFs like the iShares Core MSCI EAFE ETF (IEFA) and iShares Core MSCI Emerging Markets ETF (IEMG) have outperformed IVV (see Table 1). Gold, as represented by the SPDR Gold Shares (GLD), continues to be the best-performing major asset class recently, driven by demand from central banks. Prior to January 31, 2025, IVV had significantly outperformed equity ETFs tracking broad developed and emerging markets, both before and after the U.S. presidential election results.
Factors Driving Possible Change in U.S. Sentiment
The change in rate expectations due to inflation and tariffs has been rapid. Figure 1 highlights changes in interest rate expectations over the last six months, as measured by the CME’s FedWatch tool. The FedWatch tool estimates the probabilities of possible Federal Reserve Funds target rate ranges based on Fed Funds futures contract prices. At the end of August 2024, the indicator suggested a 76% probability that rates would be below 4% in March 2025. As recently as the end of December 2024, the tool indicated a 48% possibility of a 0.25% rate cut in March. Now, the FedWatch tool indicates that rates are unlikely to be cut before September 2025. Higher interest rates negatively impact cyclical growth sectors like IT, which has been the primary driver of the U.S. equity market.
There are other factors that also explain the recent underperformance of U.S. equities relative to Ex-U.S. equities. While earnings for S&P 500 companies have been strong (S&P estimates a 14.4% rise in Q4 2024 Y/Y), valuations are still at a 20% premium to the 10-year average (P/E of 23.1 on forward 12-month EPS, as of February 18, 2025). Equities outside the U.S. have also been boosted by developments in specific sectors like China tech and European defense.
Chinese Tech and European Defense Stocks Drive Ex-U.S. Equities
Chinese tech stocks rallied after DeepSeek’s chatbot (based on its R-1 model) became the No. 1 downloaded app on the iOS app store on Jan. 20, 2025. It highlighted the success of Chinese firms in developing competitive large language models, despite chip-level export controls from the U.S. to China. This appreciation in Chinese stocks has benefited broad emerging market ETFs as well as China tech-focused ones. Chinese stocks Alibaba Group Holding Limited, Tencent, and Xiaomi were the top three contributors to the return of IEMG this year through Feb. 19, 2024. Since January 20, the KraneShares Hang Seng TECH Index ETF (KTEC) has appreciated 25.7%, with the Invesco China Technology ETF (CQQQ) appreciating 22.4% through Feb. 20, 2025.
Another significant macro development has been the direct discussions between the U.S. and Russia over the conflict in Ukraine. Indications of a significant shift in U.S. policy have resulted in European defense stocks rallying. The Select STOXX Europe Aerospace & Defense ETF (EUAD) was up 18% year to date through Feb. 20, 2025. The largest holdings in the ETF are Airbus (24.9% by weight), Safran SA (22%), and Rolls-Royce (12.2%). The iShares Core MSCI Europe ETF (IEUR), which is diversified across industries, was up 10.8% year to date through Feb. 20, 2025. The top 10 best-performing holdings in the ETF this year include defense firms like Renk Group AG and Rheinmetall AG.
Looking Ahead
There is currently much macroeconomic uncertainty in the U.S., given the flurry of tariff-related executive actions and how they may ultimately impact consumer prices. Investors will be particularly focused on the core PCE price index, to be released at the end of February, to gauge if inflation is once again on the uptick. Trade policy and inflation are likely to be the key determinants of how U.S. equity ETFs perform relative to international ETFs in the next few months.
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