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Being overweight Europe vs. the US has been an excellent tactical trade so far in 2025. The MSCI Europe has outperformed the Russell 1000 by 9% in local currency terms and 20% in USD terms, as of May 30. While there have been several drivers of this divergence, we attribute much of it to shifting growth expectations. Specifically, the US growth outlook was downgraded due to a large hike in import taxes and European growth upgraded in part due to a generational shift in German/European fiscal policy.

Still, this stark European outperformance is a drop in the bucket compared to what has been nearly a decade and a half of ‘US exceptionalism’ (Figure 1). Was this just a blip or the start of a multi-year mean reversion? Should investors adjust their strategic asset allocation (SAA) in favor of Europe?

While several considerations go into building an SAA, two core ingredients are expected returns and a correlation matrix for the respective asset classes. As of March 10, ÃÛ¶¹ÊÓƵ Capital Market Assumptions projected MSCI Europe to return 9.1% annualized in local currency terms, and 10.8% in USD terms (the latter incorporating expected strengthening of the euro) over the course of a typical business cycle. This compares to the Russell 1000’s expected return of 7.8%. The starting points in valuation explain most of this divergence; even after recent gains, Europe remains relatively cheap vs. the US.

Of course, most capital market assumptions have projected much greater mean reversion between the US and rest of the world in recent years than has turned out to be the case, to put it mildly. But with economic policies shifting in both regions – particularly the fiscal firepower being unleashed in Europe – we think there is reason to have more confidence in higher European returns. In other words, there has long been a valuation case, but finally there is a catalyst.

The second key ingredient in an SAA – the correlation matrix – is just as important.

Cross-regional correlations, between the US and Europe, have been falling since COVID (Figure 2)

Amid shifting policy dynamics and tech concentration in the US, we think there are good reasons for these correlations to persist and remain lower than the historical average in coming years. This means adjusting an SAA with increased geographical diversification lowers overall portfolio volatility, thereby improving risk-adjusted returns. Indeed, even if US stocks were to moderately outperform European stocks over coming years, risk-adjusted returns may still be higher in portfolios that tilt more to Europe, due to greater regional equity diversification.

Does Europe deserve higher expected returns?

Equity capital market assumptions are largely built on expectations for company earnings (and dividends) as well as an assumption of valuation normalization. After some re-rating in recent years and particularly so far in 2025, European equities are no longer cheap relative to their own history. Delivering on earnings will therefore be key.

Europe faces well-known external headwinds to earnings, namely US tariffs, as well as China’s twin threat of increased competition in key export markets and a cautious Chinese consumer. But the German election of a pro-business Chancellor and an alliance responding to the threat of removal of the US defense umbrella catalyzed a German fiscal transformation that many observers had been waiting on for decades.

In the meantime, US potential growth looks set to slow from its boomy pace due to slower labor force growth and tariffs. ÃÛ¶¹ÊÓƵ Investment Bank economists forecast the US and Europe to grow at a similar pace in 2026 and 2027, a dramatic shift from the last fifteen years when (on average) US growth rose at nearly double the pace of Europe.

More interesting still is the promising right tail for European reform,

which could support both earnings growth and a higher multiple. Mario Draghi’s step-by-step plan to improve European competitiveness¹ has been embraced by pan-European institutions, and the shifting global order under President Trump is increasing the urgency among national governments to become stronger together.

A properly structured capital markets union could significantly reduce the weighted average cost of capital for European companies. Equity investors may demand a smaller liquidity and governance premium once they can trade the same security, at scale, under one rulebook. for the European Parliament finds firms in peripheral euro countries pay up to 250 bps more today because of fragmented legal regimes.² There are further gains to be made in efficiency from increasing access to capital through debt markets over dependence on bank loans. And an EU safe asset could lower individual country risk premiums more generally.

On regulation, Enrico Letta calculates that stripping back overlapping national rules and completing the services single market could free up almost EUR 700 billions in operating efficiencies – equivalent to 4% of EU GDP – by 2030. That would translate directly into wider operating margins. Other steps to improve energy efficiency and innovation intensity have the potential to further improve economic and corporate productivity.

It is natural to be skeptical given well-known European institutional rigidities, layered on top of domestic political interests and constraints. Any progress is likely to be gradual and bumpy, with disappointments along the way. In the meantime, the US maintains an edge in corporate governance and innovation, in addition to a heavy allocation to companies with exceptional earnings power. But the gap in relative valuations already reflects this advantage, and the potential upside to European reform and more stimulative fiscal policy appears to be underpriced.

The importance of correlation

Correlations between the US and European equities have broken down in recent years. This is likely due to a few factors.

The US fiscal response to COVID was more powerful (perhaps too powerful, given inflation dynamics) than Europe’s. The pull forward in digital adoption amid COVID led to a tech boom in 2020-2021 and bust in 2022, and then artificial intelligence-driven outperformance – all of which led to greater variation in tech-heavy US indexes. In 2025, the US decision to ‘take on the world’ in trade, has led to a greater markdown in the US growth outlook relative to most trading partners. In Europe, the Russia-Ukraine war and energy squeeze was a headwind in 2022, while more recently the swing towards meaningful fiscal stimulus is a tailwind.

Correlations are unstable and tend to rise sharply in severe risk-off environments. But, on average,

we see good reasons for cross-regional correlations to remain lower

than they have been historically.

The biggest reason is the scale of tech concentration in the US which, while still closely linked to global macro factors, will also trade on whether AI monetization delivers or disappoints. We expect policy differentiation to also be a key driver; due to higher debt levels and higher inflation (from tariffs), the US is more constrained on monetary and fiscal easing than Europe. Conceptually, as economic policies in the US and globally focus more on resilience and national security than efficiency, regional market performance may be somewhat less linked.

As mentioned, asset class correlations are a critical input into the strategic asset allocation design for multi-asset investors; they dictate how diversification can reduce overall portfolio volatility and increase risk-adjusted returns. Below, we take a global 60/40 equity-bond portfolio with starting weights aligned to the MSCI All Country World Index.

In the first scenario, we apply ÃÛ¶¹ÊÓƵ’s Capital Market Assumptions, which uses long-term correlations over a 30-year period, to derive the expected return, risk and Sharpe Ratio. In the second scenario, we apply the same framework and keep all the assumptions the same, except for the asset class correlations, where we use correlations over the last year. As is evident from Figure 3, in the second scenario using the recent short-term correlations, the overall volatility of a USD-based portfolio falls meaningfully from 10.9% to 9.5%, boosting the portfolio Sharpe Ratio from 0.32 to 0.36.

In the third iteration, we continue to utilize these shorter-term correlations but tilt 5% in favor of Europe vs. the US. This further improves the Sharpe Ratio, given higher expected returns and slightly lower volatility. Finally, in the fourth scenario, we maintain the lower short-term correlations and increase overall equity exposure by 5% purely via Europe (moving to a 65/35 mix). Strikingly, overall portfolio volatility remains materially lower than the 60/40 with higher correlations (10.2% vs. 10.9% volatility). Lower correlations between equity regions improve portfolio diversification so much that increases in overall equities can be funded out of the bond exposure, while still keeping expected portfolio volatility lower than a 60/40 portfolio and with a higher correlation assumption.

Figure 4 shows how, as correlations between regional equities declines, the overall Sharpe Ratio of a 60/40 portfolio improves.

The ÃÛ¶¹ÊÓƵ CMA’s project European equities to outperform US equities by 3% in USD terms. This equates to a Sharpe Ratio of 0.32 in the 60/40 portfolio using the long-term correlation matrix. However, if correlations are closer to the short-term correlation matrix, European equities can actually underperform the US by more than 1% and still deliver the same risk-adjusted return due to lower overall portfolio volatility (see Figure 5).

So while we think there are reasons for optimism that European equities can ‘finally’ outperform US equities over the coming years, they may not necessarily need to in order to deliver better risk-adjusted returns. A structurally lower correlation environment, due to US tech concentration, differentiated policy dynamics across regions, and a modestly less globalized world suggest that the appeal of geographical diversification has improved.

¹, European Commission.
² The Capital Markets Union – an extra feather to the EMU, European Parliament, September 2024.