The Long View: Diversification for uncharted waters

The investment landscape as we enter 2025 is characterized by heightened volatility and uncertainty, particularly in US equities, which have entered a digestion period typical of the third year in a bull market. This period is marked by muted returns and compounded by policy decisions such as tariffs, which have increased market unpredictability. Despite recent underperformance, US equities have historically outperformed over longer time horizons, but international stocks often gain traction when US markets struggle, underscoring the importance of diversification.

The first quarter of 2025 was notably challenging for the S&P 500, highlighting the benefits of diversification as international equities and value stocks outperformed. The recent downturn was exacerbated by the Trump administration's new tariffs, which exceeded expectations and contributed to market volatility. The ClearBridge Recession Risk Dashboard remains expansionary, but signals such as ISM New Orders worsening to red indicate potential risks. The probability of a recession has increased to 50% due to these developments, emphasizing the need for cautious investment strategies.

Diversification across geographies, market caps, and investment styles is crucial, as evidenced by the outperformance of international equities and value stocks. Historically, international equities have provided significant diversification benefits, especially when US stocks face challenges. This trend, coupled with relative valuations and potential shifts in investment flows, suggests continued opportunities in non-US markets. The maturation of the current bull market also suggests a period of consolidation before potential resumption of growth.

Policy uncertainty remains a significant driver of market dynamics, with the potential for tax cuts and deregulation later in the year potentially offering relief. However, elevated uncertainty could persist, impacting revenue growth and profit margins. Investors are advised to focus on high-quality companies with strong dividend growth, as these have historically outperformed during periods of volatility. As policy visibility improves, US equities may benefit, but maintaining a diversified approach will likely be essential in navigating the current landscape.