Financial market volatility soared last week as new tariffs for Canada, Mexico, and China went into effect, and investors reacted to a potential slowdown in the U.S. from growing economic uncertainty. European developments added to the volatility as announcements for additional fiscal spending sent shivers through the bond market but provided optimism for equity investors in certain sectors. Winners were European defense stocks, international equities, and U.S. dividend payers. Losers were non-U.S. bonds, the consumer discretionary sector, and momentum stocks. Let’s examine each of these moves in more detail.
European Defense Stocks Rally
President Donald Trump’s recent policies—such as suspending military aid to Ukraine and urging Europe to take more responsibility for its own security—have had major impacts on the global defense industry. Declining U.S. support for Ukraine has undermined confidence in American security guarantees, prompting European nations to ramp up defense spending. Meanwhile, U.S. defense stocks like Lockheed Martin have slumped amid fears of reduced demand for American-made arms.
Over the past month, European defense sector ETFs have outperformed their U.S. counterparts. The Select STOXX Europe Aerospace and Defense ETF has jumped 27.5%, while the iShares U.S. Aerospace & Defense ETF has declined 4.6%. European defense companies like Rheinmetall AG, BAE Systems PLC, and Thales SA have benefited from the expected demand for military equipment and technology driven by government commitments to increase national security budgets.
Investors Get Defensive, Shifting From Consumer Discretionary Stocks To Consumer Staples
There is growing evidence that the U.S. economy is losing momentum. Consumer confidence is slipping, retail sales are weakening, and both new and existing home sales are stagnating. Meanwhile, the inflation outlook is becoming more uncertain. As consumers grow cautious, their spending habits shift from discretionary purchases to essentials, prompting investors to adjust their stock market exposure accordingly. Necessities like food and hygiene products take priority over luxury goods and big-ticket items like cars. Companies such as Walmart, Costco, and Procter & Gamble, which cater to budget-conscious consumers, are well-positioned to perform relatively well if the economy enters a soft patch in the coming quarters..
The Consumer Staples Select Sector SPDR Fund has significantly outperformed the Consumer Discretionary Select Sector SPDR Fund over the last month. The defensive characteristics of consumer staples stocks helped push the ETF 4.3% higher, while the ETF focused on discretionary stocks fell 10.6%.
European Bond Yields Rise As Spending Plans Emerge
German 10-year bond yield rocketed 0.45% higher since the beginning of March, one of the largest moves in the last thirty years. Germany plans to implement significant changes to its budget, including creating a €500 billion fund to boost defense and infrastructure spending, as part of a broader plan to loosen its constitutional fiscal rules. This initiative, spearheaded by Friedrich Merz and supported by the CDU/CSU and SPD coalition, aims to address Germany’s aging infrastructure and enhance military capabilities in response to geopolitical tensions in Europe and U.S. disengagement from the continent. “My absolute priority will be to strengthen Europe as quickly as possible to that, step by step, we can really achieve independence from the USA,” Merz said during his first post-election interview on February 23, 2025.
Germany and other European nations plan to increase government spending over the next several years, resulting in additional bond issuance. The prospect of increased supply drove bond yields higher, leading European bonds to underperform compared to other developed debt markets. For example, the iShares 7-10 Year Treasury Bond ETF (IEF) has outperformed the Vanguard Total International Bond ETF (BNDX) over the last month. IEF gained 1.0% on the back of weaker U.S. economic data, including softer PMI services and consumer activity, and demand for safe-haven assets as stocks declined. In contrast, BNDX, which has a 56% allocation to European bonds, returned -1.8%.
Investors Pivot Away From Momentum Stocks, Dividend Payers Climb
One byproduct of market volatility and economic uncertainty is the rotation out of momentum stocks into more defensive dividend-oriented stocks. Over the past month, dividend stocks, represented by the Schwab U.S. Dividend Equity ETF (SCHD), have gained 2.6% relative to the iShares MSCI USA Momentum Factor ETF, which has declined 9.6%. Investors sought safety in companies with strong fundamentals and consistent dividend payouts with cheaper valuations rather than sticking with higher-valued growth stocks that have performed well over the last year. This divergence is another example of a shift in investor sentiment toward defensive strategies as macroeconomic risks persist.
Momentum stocks tend to suffer during times of uncertainty and when economic growth sputters. The Trump administration’s aggressive approach to restoring domestic manufacturing through tariffs and reducing the fiscal deficit via cutting government spending could slow the economy in the near term. Treasury Secretary Scott Bessent acknowledged this possibility in an appearance on CNBC’s Squawk Box on March 7 when he said there may be a “natural adjustment as we move away from public spending to private spending.”
International Stocks Outperform U.S. Equities
International stocks are gaining momentum as the narrative around U.S. exceptionalism loses steam. If the U.S. economy is slowing, and other major regions like Europe are forced to bolster their domestic economies through coordinated fiscal stimulus, the environment for non-U.S. equities becomes appealing. Investors expecting this fundamental shift in outlook are moving away from U.S. stocks, which have driven global equities higher over the past two years.
For example, the Vanguard Total International Stock ETF (VXUS) has risen 3.4% over the last month despite the global volatility in financial markets, whereas the Vanguard Total Stock Market ETF (VTI) has declined 5.8%. Aside from the gains in Europe, Chinese equities have also delivered a very strong performance so far this year. A weaker U.S. dollar, which boosts returns on foreign investments for U.S.-based investors, is also contributing to the strong performance of non-U.S. stocks. U.S. investors who previously had limited exposure to international markets may see recent geopolitical developments as an opportunity to diversify their portfolios by increasing investments outside the U.S.
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