The fourth quarter of the year has historically seen the best performance, at least for US and emerging market equities. Can we look forward to a happy holiday season?
The Grinches among us would think it unlikely: strong returns in the last quarter of the year typically follow poor returns in the prior quarter. When third quarter returns were around the 7.8% we saw this year, the average fourth quarter return was zero, though those returns ranged widely from -23% to 17% (see Exhibit 1).
Given the good US equity returns in the last quarter, one might expect a pause in the months ahead, or even a decline, should stretched valuations become a factor.
Fundamentals and events will determine the returns we actually see. Optimists looking for a result on the plus side of the historical range would point to a positive earnings trajectory reflecting economic momentum globally, albeit greater in the US than elsewhere: US growth is on track to hit 3.9% in the fourth quarter according to the Atlanta Fed, and 2026 Bloomberg consensus GDP forecasts have moved up from a low of 1.5% post-Liberation Day to 1.8% today; for the eurozone they have slipped lower from 1.2% to 1.1%.
There are inevitably other, negative, signs for the outlook. Most major economy manufacturing purchasing managers’ indices (PMIs) are below 50, indicating contraction (see Exhibit 2). Services PMIs, however, are mostly above 50.
The US labour market is weaker than had been thought, though its current state is unclear, given the lack of data due to the US government shutdown.
But even feeble job creation in the US is not an obvious binding constraint on growth given that the unemployment rate is still low. Whether it moves up or down from here, along with wages, will depend on the participation rate and whether it rises enough to offset the drop in labour market supply from restricted immigration and deportations.
Europe struggles
European corporates are struggling in the face of US tariffs and a stronger euro. The naïve scenario imagined after the US election was that tariffs would be modest and offset by a depreciating currency.
Instead, European companies are seeing a drop in exports to the US and are having to absorb themselves a large part of the tariffs. In addition to drop in sales to the US, domestic competition is increasing as China redirects to Europe some of the exports previously destined for the US.
The disruption to the international political and economic order unleashed by the new US administration has spurred Europe to try and reduce its dependence on the US, for example by increasing its capabilities in defence — an initiative called Strategic Autonomy.
Many investors are looking for fiscal stimulus directed to infrastructure and defence to begin boosting corporate profits. How quickly the government can spend the money given capacity constraints remains to be seen. Deregulation would accelerate deployment of the capital, but implementation is proving to be a challenge.
Stocks linked to the strategic autonomy theme have still outperformed the broader index. Year to date, the Euronext European Strategic Autonomy (ESA) index has gained 20% (in euro terms) versus 15% for the MSCI Europe ex-UK index. The degree of outperformance, however, has not increased: the ESA index has outpaced the broad index by about the same amount over the last 15 years (see Exhibit 3).
By contrast, there has been a big jump in the outperformance of the aerospace and defence (A&D) sector, as the chart illustrates. But, the gain in prices has not yet been matched by a commensurate increase in earnings. As a result, the forward price-earnings (P/E) ratio for the A&D index is up by nearly 40% from 21x to 29x. It is hardly comforting that the US equivalent has risen by the same amount.
Earnings will need to rise sharply to sustain this multiple, but the profits generated by European Union (EU) defence spending are unlikely to go entirely to EU companies (despite the EU’s 65% target for spending within the EU or Ukraine).
The sector is undersized after decades of low investment post-World War II and it does not have the capacity to quickly absorb a significant increase in demand. US firms account for nearly 60% of industry net income, and will inevitably see a meaningful share of EU spending. Reliance on US production will drive up EU imports, lowering European GDP growth and dampening some of the positive benefits from the region’s initiative.
This is not to suggest the increase in spending will not boost European growth and corporate profits, only that investors need to have reasonable expectations, particularly given the high sector valuations.
China looks for a new model
The risks to Chinese economic growth are biased downwards rather than upwards. Tariffs and persistent problems in the property market will likely continue to weigh on activity, while the government’s recent ‘anti-involution’ initiative could drag further on activity if manufacturing investment falls.
The government will likely continue to roll out stimulus programmes to spur demand, but as recent third quarter 2025 GDP data showed, consumption has barely increased (despite numerous previous stimulus packages) due to depressed consumer sentiment.
The broader challenge for both China and the EU is how to adapt their economic models to a world where growth cannot be derived by simply exporting products to the US. Europe has started down a new path with its infrastructure and defence initiatives. China is counting on new growth engines to keep the economy expanding at pace, but excess production capacity remains a key challenge.
Emerging market tech stocks
To some degree, the focus on the Magnificent 7 and the NASDAQ index has overshadowed opportunities within the emerging market tech sector. There is no single index like the NASDAQ to benchmark the sector (though there are some smaller exchange-traded funds (ETFs)). This leaves investors having to choose between country, region or style indices, which inevitably include a large share of non-tech stocks.
It is the tech factor, however, which explains most of the outperformance of emerging market equities. While investors are well aware of the outsized contribution of tech stocks to the performance of US equities, they may not realise that the outperformance of tech shares in emerging markets is even greater.
Since 2008, the US NASDAQ 100 index has outperformed the Russell 1000 Value index by 300%, while emerging market tech sectors1 have outperformed the non-tech parts of the market by nearly 500% (see Exhibit 5).
It is important to note that the outperformance of EM tech is not because it has bested the NASDAQ. Over this period, returns for the NASDAQ have been twice those for EM, but the returns for the Russell Value index have been eight times better than the non-tech parts of emerging markets (USD terms).
We believe the medium-term outlook for technology-sector earnings globally remains positive. The support from the development and rollout of artificial intelligence (AI) is well understood, though some investors are concerned about exposure to China, which accounts for a third of the EM tech basket.
Restrictions on US technology transfer could limit earnings growth. Indeed, forward earnings per share (EPS) estimates for Chinese tech companies have lagged the rest of the market (see Exhibit 6), though this is due primarily to Alibaba. Tariffs should be less harmful for technology stocks as their revenues come primarily from services rather than goods.
We believe the size of the domestic market, the high level of engineering talent (cf. DeepSeek), and China’s desire to develop its own technological ecosystem will drive meaningful profit growth in the future, despite challenges for the domestic economy.
Value options
To balance growth exposure in portfolios, investors have the choice among indices of the US Russell 1000 Value index, MSCI Europe or MSCI Japan, which all have a similar sector composition. As Exhibit 6 shows, the trajectory since the summer for expected earnings is broadly similar for all three. Expectations for year-on-year earnings growth in 2026 are 9%, 13% and 14%, respectively.
Japan currently has momentum thanks to the election of Sanae Takaichi as prime minister, boosting expectations for economic stimulus and a weaker yen. On a longer-term view, valuations may play a bigger role, and here Europe is by far the most appealing. The z-score for the forward price-earnings ratio of the MSCI Europe index is only 0.2 compared to 1.5 for Russell Value and 1.6 for Japan.
Earnings season
The third quarter earnings season has started out well, with a particularly high number of companies raising their guidance. This optimism partly reflects the extreme pessimism that reigned immediately following Liberation Day; things have turned out much better than expected and corporate messaging reflects the better outlook (see Exhibit 7).
Earnings growth expectations are high for growth sectors next year, with NASDAQ earnings forecast to rise by 15% (after a 25% gain in 2025), and EM tech by 30%. Earnings growth at these levels offers a possible solution to the problem of high valuations.
Concerns about high multiples for the S&P 500 often focus on the Mag 7, but for tech stocks broadly, valuations are not at extreme levels. The forward P/E ratio for the NASDAQ is around 28x. This equates to a z-score of 0.5 — high but not extreme. On the other hand, the peak NASDAQ P/E in 2021 was not much higher at 30x, and high multiples contributed to the dramatic sell-off in tech in 2022.
The obvious difference is that the US Federal Reserve (Fed) will likely be lowering rates in the quarters ahead instead of raising them. A benign way that the index multiple could revert towards its mean would be for the index price to appreciate less than the gain in earnings over the next year. With forecasts of 15% earnings growth in 2026, there is still room for good investment returns.
Small-cap equities
This dynamic of prices rising at a slower rate than earnings would also resolve high multiples for US small cap stocks.
The Russell 2000 forward P/E is elevated, with a z-score of 1.5, but earnings growth is also very strong, forecast to advance by 22% next year.
Given the positive macroeconomic backdrop for the US (deregulation, more mergers & acquisitions (M&A) activity, rising business investment, wage growth, falling policy rates, and low energy prices), we are optimistic that these earnings expectations will be largely realised.
It is notable that the Russell US small cap index is one of the few small cap indices that is still outperforming large cap indices around the world, with the important caveat that the comparison should be small cap indices versus the Russell Value index in the US, or EM ex-technology in emerging markets (see Exhibit 8). Small cap stocks are unlikely to sustainably beat US or EM large cap indices given the weight, and superior performance, of the technology sector. But small cap indices offer an alternative way to access growth without increasing exposure to the tech sector.
[1] Technology, Broadline Retail, Interactive Media & Services.
