Global Diversification and AI Productivity Boosts Amid US Equity Rotation

Deep Dive

The 2025 investment landscape is characterized by a significant rotation away from the US markets, driven by a confluence of factors including relative valuations, evolving fiscal policies in Europe, and the transformative potential of artificial intelligence. This shift suggests that investors who over-concentrate in US equities, particularly technology-heavy indices, may face increased risk as global opportunities and defensive strategies gain prominence.

Emerging markets, both debt and equity, present a compelling case for global investors seeking diversification and access to substantial economic growth. Hendrik du Toit highlights that these markets have historically outperformed developed markets and continue to offer a premium over developed market debt, despite recent volatility. The underlying economic trends in countries like China, India, and Brazil indicate a long-term trajectory that challenges the dominance of G7 economies. This diversification is crucial for hedging against regional risks, as demonstrated by the value destruction seen in Eastern Europe due to geopolitical events. The narrative of US exceptionalism and a strong dollar, while currently dominant, may not persist indefinitely, underscoring the need for a global investment perspective.

Cliff Asness of AQR Capital Management argues that the outperformance of US equities over the past quarter-century has been largely driven by multiple expansion rather than fundamental growth differentials, making the US market relatively expensive compared to international equities. This valuation gap suggests that a diversified global portfolio is prudent, as assuming continued US outperformance at the same historical margin would require stratospheric multiple expansion. Similarly, Vincent Montemaggiore notes a rotation into European markets, attributing it partly to the US market being "crowded and expensive." Crucially, Europe is experiencing a shift away from austerity, with increased fiscal spending on infrastructure and defense, particularly in Germany, which is expected to stimulate growth and potentially lead to higher interest rates. This environment benefits sectors like industrials, building products, and defense, as well as banks and insurance companies sensitive to yield curve movements.

Artificial intelligence is emerging as the dominant investment theme, with economists characterizing it as a general-purpose technology with the potential to significantly boost global productivity growth. While adoption is still in its early stages, estimates suggest a potential increase in productivity growth of one to one and a half percentage points annually in the decade following widespread adoption. However, the dissemination and benefits of AI may be unevenly distributed due to global economic fracturing. The US leads in AI development and diffusion, but policies like labor market reforms and immigration clampdowns could diminish its adaptability. Simultaneously, restrictions on China's access to US technology may force it to develop its own, albeit potentially slower. The impact of AI on investment returns is also evolving, with an expected shift from cost-cutting applications to revenue-generating AI-native business models over the next five years, though short-term "air pockets" are possible.

The investment implications of AI extend beyond traditional tech sectors. Joe Davis of Vanguard predicts that transformative technologies like AI will disproportionately benefit companies outside the tech sector, such as those in consumer staples and automotive industries, which utilize AI as a platform for growth, even if they are not direct AI producers. This suggests that opportunities may lie in companies with lower multiples outside of Silicon Valley.

Amidst this evolving landscape, investors are cautioned against over-allocating to private equity. Daniel Rasmusson points out that while the opportunity set in private markets appears vast, the aggregate profit share of private firms is small, and private equity deals are typically micro-cap, which are inherently riskier and less liquid than larger public companies. The significant overweighting of private markets in institutional portfolios, coupled with high fees and leverage, creates correlated risk. Furthermore, evergreen funds investing in illiquid assets, such as interval funds and business development companies (BDCs), present unique challenges. Investors must understand that these instruments do not offer the same liquidity as traditional mutual funds or ETFs, and capital may not be readily accessible, especially during market stress. The lack of transparency in these lightly regulated private debt markets raises concerns about unforeseen risks and transmission linkages, echoing lessons from the 2008 financial crisis.

In conclusion, the investment environment is shifting, with a move towards global diversification and a cautious approach to concentrated US tech exposure. While AI promises significant long-term growth, its benefits may spread beyond the technology sector, and investors must navigate the complexities of illiquid private markets and evolving global economic dynamics. The enduring principle for investors remains that over time, equities in healthy economies tend to outperform inflation, but achieving this requires a disciplined, long-term perspective that accounts for cycles and avoids reactive decisions based on short-term market fluctuations or perceived valuations.