Market Correction, Tariff Chaos Revive Power Of Diversification

Forbes

04-04-2025

The first three months of 2025 marked the worst quarter for the S&P 500 Index since 2022, bringing the benefits of diversification back to the fore. Then came the Trump administration's 'Liberation Day' tariff announcements on April 2, which led to a new round of selling as the announced tariff rates exceeded even the most pessimistic expectations. Much remains unknown including the possibility of trade deals being reached. However, with the economy and markets entering uncharted waters, the balance of economic and market risk has shifted unfavorably, in our view.
Deteriorating sentiment has been one of the key risks emerging given the elevated uncertainty over the past few months, but the degree to which weaker 'soft' survey data translates into poor 'hard' results will be critical. Looking ahead, we would expect indicators like credit spreads and commodities to be the first areas to roll over.
We believe the probability of a recession over the next 12 months is in the neighborhood of 35%, a figure we are subjectively increasing to 50% due to the worse-than-expected tariff announcement and our perception of risks skewing negative for the economy and markets. Our assessment of the economy incorporates many indicators as well as our own judgement and experience, along with that of our colleagues at ClearBridge. In speaking with our colleagues over the past few days, three words best encapsulate the recurring themes across those conversations: skepticism, unknowns and diversification.
Skepticism and unknowns are specific to the current environment; skepticism regarding the near- and intermediate-term consequences of recent policy decisions, which the market is signaling may be worse than the administration believes. Unknowns on the positive side include the potential for more market-friendly policy developments such as trade deals and the possibility that tariff revenue is used to fund larger than expected tax cuts. Conversely, there are risks that the long-term benefits the administration is seeking may fail to offset the associated costs. This line of thinking drives our perception of an unfavorable risk skew, which leads to the third recurring theme: diversification.
Over the past several years, diversification has felt less like the free lunch described by Nobel Laureate and modern portfolio theory pioneer Harry Markowitz, and more like a drag on returns. This has been a headwind to active managers as a narrow group of stocks powered most of the benchmark's upside. However, owning diversified portfolios is now paying off. According to Strategas Research Partners, 59.8% of active managers outperformed in the first quarter. If that were to hold up for the balance of the year, it would mark the second-best year for active managers since the Global Financial Crisis (GFC).
The importance and benefits of diversification apply at many levels, a fact many investors were reminded of in the first quarter with the previously red-hot Magnificent Seven stocks falling -16.4% while left-for-dead international equities (MSCI All Country World Index ex-US) rose 4.6%. While the relative outperformance of non-U.S. stocks has garnered the lion's share of headlines lately, value stocks in the S&P 500 have outperformed their growth counterparts by 11.7% so far in 2025. Part of the reason that geographic leadership has been in focus, however, is that it stands in stark contrast to consensus expectations coming into the year that U.S. equities would handily outpace their international peers once again.
Historically, international equities have provided the greatest diversification benefits when U.S. stocks have been challenged. While this can occur on a short-term basis like what we've seen recently, the effect is magnified over longer time horizons. Since 1971 when the S&P 500 has delivered less than 6% annualized over a 10-year period, the MSCI EAFE (developed) and the MSCI Emerging Markets indexes have outperformed by an average of 2.0% and 12.1%, annualized, respectively. Importantly, the hit rate for outperformance is greater than 90% for each benchmark. Although the U.S. has outperformed over the long haul, international equities tend to pick up the slack when U.S. markets falter.
One dynamic helping support investor focus in non-U.S. stocks is relative valuations, with the cohort still trading near 25-year lows to U.S. peers even after this year's robust outperformance. U.S. investors are quite underweight international equities while non-U.S. investors have poured over $9 trillion into U.S. stocks over the past five years, according to research from Apollo. Should these flows reverse, it could lead to continued upside for the group, bolstering the diversification benefits.
An underappreciated aspect of recent equity market weakness may be the typical maturation of the bull market, with new bull markets experiencing a period of digestion during their third year before seeing a resumption of the rally in year four. The current bull market had its third birthday approximately six months ago, meaning we are square in the middle of the historical digestion period.
The primary driver of recent market weakness — and one that is certainly not underappreciated — has been elevated policy uncertainty, however. Coming into the year, our view was that policy sequencing presented a risk of first-half choppinessas the administration prioritized less-market-friendly policies (tariffs, immigration, DOGE) before turning to more market-friendly goals (tax cuts, deregulation). Should visibility emerge in the coming months and uncertainty fade, one overhang on U.S. equities would ebb. Historically, when the U.S. Policy Uncertainty Index, a measure compiled by financial economists at three leading universities, has been high (above 155), as is the case today, the S&P 500 has delivered average returns of 9.3% over the subsequent six months and 18.1% over the subsequent 12 months.
Jeffrey Schulze, CFA, is Director, Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.