The great rotation: When valuations matter again

Commentary by Andrew Shuman, Director of Research, Vanguard Oversight & Manager Search, and Kevin Khang, Vanguard Senior Global Economist

On our “Market views” tab: Oil curve points to shock, not lasting disruption
 

More than a decade of U.S. equity market leadership was interrupted by a historic rally in non-U.S. equity markets last year. Now, investors are debating whether the long‑anticipated “great rotation” is finally taking shape. 

Those on the “yes” side of the debate see market strength as broadening beyond mega-cap, tech-heavy U.S. equity to capital-intense industries globally. Across the world, infrastructure investment, energy security initiatives, and supply‑chain reshoring are moving from planning stages to execution. This means accelerated investment in physical goods and earnings growth in sectors close to this shift.

Europe provides a clear example. Increased defense spending and accelerated investment in renewable energy are supporting multiyear demand for capital‑intensive sectors such as industrial equipment, materials, and utilities. These trends favor companies with tangible assets, long‑dated cash flows, and pricing power—areas that had been underrepresented in global portfolios during the asset‑light growth era. The effects are also visible in commodities markets and in emerging economies that supply key inputs for these projects.

Additionally, the investment footprint of an AI-driven capital buildout reaches well into the broad U.S. equity market. The spending requirements associated with AI are driving demand for semiconductors, advanced manufacturing equipment, and electrical equipment. Many of the key companies benefiting from this development are listed outside the U.S.

AI is reshaping sector dynamics within the U.S. too. Utility and energy companies—historically valued for income rather than growth—are seeing improved valuations as electricity demand rises and grid investment accelerates. 

Those on the “no” side of the great rotation debate see continued investing merit in tech-heavy U.S. equities. Over extended horizons, equity returns tend to be driven by a relatively small number of highly successful firms. While these firms change over time, the U.S. continues to be the primary incubator of such companies. Deep capital markets, a strong venture-capital ecosystem, and a culture of innovation all support the creation and scaling of new technologies.

The U.S. also benefits from institutional features that support rapid adoption of innovation. Flexible labor markets, comparatively strong corporate governance, and a culture of risk-taking all increase the likelihood for productivity gains that translate into earnings growth.

Geopolitical considerations reinforce this position. The U.S. operates as a large, relatively self‑sufficient economy with robust domestic energy and food supplies. In periods of heightened geopolitical uncertainty, as we’re currently experiencing, this insulation has tended to support capital flows into U.S. assets and to limit relative volatility. These characteristics help explain why investors continue to assign a premium to U.S. equities.

Valuations remain central to the rotation discussion. While valuations are not a timing tool, they play a critical role in shaping outcomes as market narratives evolve. Market movements in February underscored the risks associated with stretched valuations. The sharp decline in parts of the software and IT services sector following heightened concerns about AI‑driven disruption illustrates how quickly sentiment can change due to the prospect of business model disruption. After years of strong performance and rising multiples, these stocks had little valuation cushion when narratives turned.

Whereas stretched valuations leave stocks vulnerable to a sudden business model disruption, the low expectations underlying low valuations can provide resilience—and potential upside. As shown in the accompanying chart, many non-U.S. companies entered 2025 with historically attractive valuations and, when sentiment improved, the most attractively valued stocks appreciated the most.

The Standard & Poor’s 500 Index continues to trade near the upper end of its historical valuation range, reflecting both strong earnings growth and a premium assigned to U.S. corporate resilience. By many measures, it is a stretched valuation that requires continued earnings growth and, importantly, a lack of economic developments that call this trend into question.

In contrast, many non-U.S. equity markets continue to trade closer to long‑run averages. Granted, the valuation gap between U.S. and non-U.S. equities has narrowed following last year’s rally. However, after years of U.S.-driven equity market growth, continued optimism underlies current U.S. valuations, whereas guardedness surrounds non-U.S. equity valuations. Similarly, many segments of the global equity market outside of the mega-cap tech space continue to be under-owned in global portfolios. 

Today’s environment presents a very different backdrop from what persisted for most of the past decade, when U.S. large-cap growth equities reliably and consistently outperformed, making style, market capitalization, and regional diversification seem unnecessary. Against the current backdrop, our view remains that within the equity portion of their portfolios, investors would benefit from the diversification derived by leaning into more reasonably valued market segments, both U.S. and non-U.S. Such diversification adds resilience and upside potential should fast-moving AI, which has started to disrupt many businesses and investment narratives, diffuse through the global economy.