The extent to which the inflation and interest rate shocks of 2022 are reshaping the dynamics of international (ex U.S.) equities should become clearer in 2025. We expect there to be more evidence of a broadening opportunity set that favors international stock markets—and, within them, value and small‑cap stocks and countries such as Japan and South Korea.

We are emerging from a highly unusual period in which one market (the U.S.) and one sector (technology) dominated returns—and within that sector, a handful of exceptional firms drove the large bulk of those returns. This dominance has skewed investor positioning and valuations: Many investor portfolios are heavily exposed to U.S. equities while virtually every sector in non‑U.S. equities is currently cheaper than its U.S. equivalent.

Small‑caps appear positioned to deliver strong earnings growth

Valuations alone are not a compelling reason to invest in a particular market or asset class, but they do provide a useful starting point when determining the potential for long‑term returns. Within international markets, value stocks have been trading at a discount to growth stocks. This is likely to change as we expect non‑tech capex (capital expenditure) to surge amid widespread factory automation and the relocation of supply chains. The fastest‑growing firms in the period following the GFC were U.S. tech companies whose business models were built around intangible assets. We expect the period ahead to be marked by a higher‑trend level of demand for tangible assets, supporting sectors such as industrials, energy, and materials, which are typically value oriented.

International small‑caps (typically represented by the MSCI All Country World ex-USA Small and Mid Cap Index) usually traded at a premium to large‑caps, but in 2024 this premium disappeared following several years of COVID‑related disruption and supply chain challenges (Figure 1). In our view, international small‑caps offer the potential to deliver stronger earnings per share (EPS) growth than their international large‑cap peers in the period ahead as the economic environment improves. History shows that following periods of earnings decline, earnings growth for small‑caps have typically exceeded large‑caps. We expect this to occur again on this occasion, but this time coming from a point of extreme valuation support for small‑caps that should help compound investor returns.

The bull case for Japan still holds

The world will likely need to get used to a structural downshift in China from the 5% to 6% growth rates seen over the past few decades. A further challenge to Chinese growth may come if U.S. President-elect Donald Trump delivers on his promise to impose more tariffs on China—although it is not yet clear how far any new measures will go, nor how much scope there is to negotiate a new trade deal between the two countries. In the meantime, the combination of compressed valuations, bottom‑up innovation, and potential for strong countertrend rallies means that opportunities to invest in China will continue to arise.

We believe the medium‑term bull case for Japan still holds as Japanese firms switch focus from market share to profit maximization. Although it is still in the early days, South Korea has sought to emulate Japan’s success in boosting stock valuations with a corporate governance drive. Tax incentives have been offered to businesses that prioritize shareholder returns, while the new “Korea ValueUp Index” will list firms that have improved capital efficiency.

These are significant structural opportunities available at attractive prices.

Key takeaway
We anticipate a broadening opportunity set that favors international markets, particularly value and small‑cap stocks.