US Policy Changes Highlight Need for Portfolio Diversification

After a prolonged period of US outperformance, many investment portfolios have become heavily concentrated in US equities, particularly tech stocks. They are also significantly exposed to the US dollar across public, private, and alternative assets. Recent policy shifts now challenge US economic and financial hegemony, increasing the risk to equity and currency outperformance. Investors should carefully evaluate these exposures to determine if greater diversification is warranted.

Having outgrown its Eurozone peers in the 12 to 15 years since the Global Financial Crisis, continued US economic outperformance was unsurprisingly anticipated this year. As of the end of February, the consensus expectation for 2025 GDP growth was 2.3% for the United States versus 0.9% for the Eurozone. However, recent US tariffs have disrupted these forecasts, impacting global growth and inflation expectations. The growth impact outside the United States will depend on how long the announced tariffs are in place, the degree of demand destruction, and the extent of any retaliation. In contrast, the uncertainty for US businesses and consumers seems likely to weigh substantially on growth even before the direct impact of the tariffs is felt. As a result, growth expectations have converged, with latest forecasts projecting economic growth of 1.7% for the United States and 0.8% for the Eurozone this year.

Even before this, however, structural change was afoot within Europe. Germany’s pivot from fiscal orthodoxy to significant infrastructure and military spending, alongside the EU’s push for increased defense budgets, signal a proactive response to weak growth and geopolitical changes. At the same time, the Trump administration has vowed to reduce the US budget deficit. While the running deficit is actually up on the year so far, there appears to be limited room to meaningfully expand the current 6%+ deficit. Furthermore, the inflationary impact of tariffs in the United States may frustrate the swiftness and extent with which the Federal Reserve can provide support. By contrast, inflation in Europe is closer to target, while US tariff policy should prove disinflationary for the region. All told, Europe should have more policy flexibility to mitigate the impacts of the tariff regime. Therefore, further convergence in expected growth rates look more likely as the year progresses.

Consistent with this, the US equity market has underperformed its peers this year, with the challenge to US growth conditions from tariffs serving as the catalyst. However, it has not been just those sectors with the greatest direct exposure to tariffs that have underperformed the most, but also the most richly valued companies, which have a large weight in US indexes. Clearly, recent policy volatility is not consistent with the broadly accommodative macro conditions that are required to keep valuations near historically elevated levels. Despite recent declines, growth stock valuations remain elevated compared to the broader market. As a result, we continue to recommend that investors moderately tilt towards developed markets value equities, which offer a margin of safety. The resulting modest overweight to ex US equities reflects the growing importance of regional diversification as US capital attraction faces policy-driven challenges.

While there is some underlying diversity in US equity exposures, namely across different sectors (even if somewhat diminished recently) and globally derived revenues, one of the most concentrated exposures in many portfolios is the US dollar. Given the US weight in both public and private markets, as well as some alternative strategies, it is not uncommon for European portfolios to have an exposure of 40%–50% to the US dollar. Thus far, investors have been well served by their dollar exposure. It has both been in an uptrend for the past 14 years and acted as a partial hedge for portfolios, reliably rallying when risk assets declined. There are reasons to question whether these trends for the dollar will continue. As the US dollar valuation reapproached its most extended levels in recent months, we believed that growth and interest rate convergence between the United States and its peers was likely and presented downside risks for the greenback. We continue to hold this view, and now add to the list of drivers a potential structural reduction in demand for US assets prompted by evolving trade and geopolitical policies.

What’s more, the United States has been the source of the recent market volatility, with fears of its economic underperformance and foreigners’ desire to repatriate capital depriving the dollar of its risk-off qualities. If future bouts of volatility also originate from, or are centred on, the United States, it may continue to disappoint as a hedge. Similarly, it may turn out that recent US policy actions end up accelerating what has been the glacial erosion of the dollar’s dominant reserve currency status. Therefore, if in times of stress, foreign investors come to view the United States as a funding source, rather than a destination for capital, the dollar may behave differently than in times past. This, of course, is not pre-ordained, but the subjective probability has increased. For now, as the dollar remains the dominant currency of trade and account, it retains the capacity to appreciate in the event of a global dollar funding squeeze. A reversal in current tariff policy could also see the dollar gain some short-term support.

There is no one-size-fits-all approach to dealing with concentrated positions within portfolios. Broader diversification can help reduce risks tied to a single economy. Reducing overall US dollar currency exposure—whether through greater domestic currency investment or increased currency hedging—may also improve diversification, though each approach involves its own opportunity and explicit costs. Furthermore, such decisions cannot be taken in isolation, as they are inherently linked to other portfolio decisions, such as the size of safe-haven bond allocations and other diversifier allocations. Overall, awareness of exposures, understanding how they may behave in different environments, and diversifying those that present excessive risks remains key to prudent portfolio management.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research