U.S. equities have lagged many foreign markets in recent weeks, but that pattern may not endure, according to analysts at Capital Economics. While overseas peers have surged relative to U.S. stocks on a short-term basis, the firm notes that American companies still trade at high valuations and carry stronger expected earnings growth than most countries in the MSCI All-Country World Index (ACWI).
The S&P 500 recently climbed above the 7,000 level for the first time, a move driven by persistent optimism around artificial intelligence and hopes for Federal Reserve interest rate cuts later in the year. That rally has been notable - the index has risen by roughly 1,000 points since November 2024 - and has occurred amid what analysts describe as relative economic resilience despite geopolitical and trade uncertainty.
Investors also appeared to set aside immediate concerns about a sharp slide in the U.S. dollar this week, yet Capital Economics flagged that the dollar's volatility is likely weighing on the relative performance of U.S. equities. In a client note, the team, which includes James Reilly, pointed to data showing widespread foreign outperformance in the short term.
Specifically, among the countries included in the MSCI ACWI excluding the U.S., 93% have outperformed MSCI's U.S.-focused average over the past two months. The margin of that outperformance is about 8%, which the analysts characterized as "significant."
Capital Economics drew a provocative comparison - observing that this pattern of strong foreign returns alongside U.S. gains resembles dynamics seen during the late 1990s and early 2000s dotcom episode, when speculative fervor around internet companies produced an outsized U.S. market boom that later collapsed. The analysts cautioned that the present situation bears some resemblance to that prior period.
Even so, the analysts emphasize that it is premature to assume U.S. equities will continue to lag. Their analysis finds that only two countries currently have higher valuations than the U.S., and only eight are forecast to deliver faster earnings-per-share growth than the MSCI U.S. index over the next 12 months. Those comparisons, they argue, suggest U.S. stocks remain relatively richly priced and expected earnings growth remains elevated relative to most peers.
Capital Economics spelled out two plausible interpretations. One is that U.S. equities have further room to underperform given the optimism already priced in. The alternative is that the market concern about U.S. weakness is exaggerated, and the recent divergence could prove short-lived within another year of U.S. outperformance.
The analysts concluded that both views have merit: they expect U.S. equities to underperform over the long run because of the high optimism embedded in current prices, but they forecast that U.S. stocks will likely beat most peers during 2026 as the valuation "bubble" expands further in the near term.
Summary
Capital Economics finds that despite a recent spell in which non-U.S. markets have outpaced U.S. equities, fundamentals such as valuation and expected earnings growth remain stronger in the U.S. than in most other countries within the MSCI ACWI. The firm views the current divergence as potentially temporary, noting both the risk of longer-term U.S. underperformance and the likelihood of continued near-term U.S. strength.
Key points
- Short-term foreign outperformance: 93% of non-U.S. countries in the MSCI ACWI outperformed the MSCI U.S. average over the past two months by about 8%.
- U.S. fundamental strength: Only two countries have higher valuations than the U.S., and only eight are expected to achieve faster EPS growth than the MSCI U.S. index in the next 12 months.
- Market drivers: The S&P 500 rallied above 7,000 for the first time on AI optimism and hopes for Fed rate cuts, gaining roughly 1,000 points since November 2024.
Risks and uncertainties
- Currency swings: A sharp decline in the U.S. dollar has coincided with relative U.S. underperformance, and further currency volatility could continue to influence equity returns across sectors tied to international trade and multinational earnings.
- Valuation vulnerability: Elevated U.S. valuations and high expectations for earnings growth raise the risk of longer-run underperformance if optimism proves excessive, which could impact tech-heavy sectors sensitive to sentiment.
- Comparative returns: Because a large majority of non-U.S. markets have recently outperformed, there is the uncertainty that this relative strength could persist beyond the short run, affecting portfolio allocation decisions in international and emerging market equities.