International Stocks Face Geopolitical Test as Oil Shock Exposes Fragile Re-rating

The 2025 performance for international stocks was a seismic shift in market expectations. For over a decade, US equities had dominated, but that narrative flipped hard. While the S&P 500 gained 17%, the Morningstar Global Markets ex-US Index soared 32% in US dollar terms. This wasn't just a beat; it was a reset of the entire global equity story.

Investors didn't just watch this outperformance-they chased it. The move sparked a massive capital shift, with $57 billion flowing into international equity funds last year. This was the market's verdict: the era of "American Exceptionalism" was over, replaced by a "Sell America Trade" driven by policy and a long-overdue reversion to cheaper valuations.

Yet, here's the critical tension. Despite the spectacular 32% rally, the expectation gap remains wide. Even after the surge, non-US stocks were recently about 35% cheaper than US stocks based on forward P/E ratios. In other words, the massive performance gain of 2025 was largely a catch-up to a deep valuation discount. The market had priced in years of underperformance, and the 2025 move was the correction.

Now, the test of sustainability begins. The powerful reset has happened, but the question is whether the new, higher starting point is durable or a fleeting rally. The 2025 surge was a massive expectation reset, but its durability is the new reality being priced in.

The 2026 Stall: Testing the Durability of the New Normal

The powerful expectation reset of 2025 is now being tested by a new reality. While international stocks remain ahead for the year, their recent underperformance against the US market is a clear signal that the market is questioning whether the surge was a sustainable trend or a one-time re-rating event.

The data shows a sharp divergence. So far in 2026, the Vanguard Total International Stock ETF (VXUS) is up 9% year to date. But this lead is rapidly eroding. Over the past three trading days, the S&P 500 trounced the MSCI AC World ex-USA Index by nearly 6 percentage points, its largest three-day outperformance against international stocks in months. This is not a minor fluctuation; it is a targeted repricing.

The mechanism is geopolitical. The conflict in Iran and the resulting spike in oil prices to around $80 a barrel are disproportionately hurting international stocks. The key vulnerability is energy exposure. As J.P. Morgan's chief strategist noted, the U.S. is a net exporter of oil, and you can't say that about Europe, or China or Korea. For these major economies, higher oil prices are a direct drag on corporate profits and consumer spending, translating into weaker equity performance. The US, by contrast, is less exposed to this specific headwind.

This recent weakness suggests the market is resetting its expectations again. The 2025 rally priced in a durable shift in global leadership. Now, a geopolitical shock is testing that thesis. The fact that international stocks are getting hit harder than US equities in this scenario indicates that their recent outperformance may have been built on a fragile foundation of low energy costs and stable geopolitics. The expectation gap is closing, but not in the way many hoped. The new normal is proving more volatile than the old one.

The Core Expectation Gap: Growth vs. Geopolitical Risk

The market is now weighing two powerful, opposing forces. On one side are the fundamental growth catalysts that were not priced in before 2025. On the other, a new wave of geopolitical and stagflationary risks that are only now being reflected in valuations. This is the heart of the current expectation gap.

The growth story is anchored in two regions. In Europe, countries like Germany making big spending moves are set to fuel economic expansion, supported by dovish central banks. In Japan, a long-overdue corporate restructuring effort is unlocking value and boosting productivity. These are structural shifts that promise durable outperformance, and they were largely absent from the market's narrative just a year ago. The 2025 rally partially priced them in, but the expectation now is for them to drive the next leg higher.

Yet, this fundamental optimism is being challenged by a renewed energy shock. The conflict in Iran has revived fears of a stagflationary environment, where growth slows but inflation persists. This is a critical risk because it raises the possibility of a "stagflation" concern-raising the risk that stocks and bonds fall together. For international portfolios, this is a heavier burden. As noted, the U.S. is a net exporter of oil, while major international economies are not. So, a spike in oil prices hits their profit margins and consumer spending more directly, creating a double hit to corporate earnings.

The market's current stance is one of cautious recalibration. The AI optimism that drove markets early in 2026 has been tempered by mounting uncertainty about funding the AI buildout and its ROI. This adds to the pressure on software stocks and widens sector gaps. Against this backdrop, the new geopolitical risk from the Middle East is not yet fully priced into international equities. The expectation gap is clear: the market is still weighing the promise of European infrastructure and Japanese restructuring against the very real threat of a stagflationary shock that disproportionately affects overseas holdings. The outcome will determine if the 2025 reset was a durable trend or a fleeting rally.

Catalysts and Watchpoints: What Will Close the Gap?

The expectation gap between international and US stocks will be resolved by a series of near-term events. The market is now waiting for concrete signals to determine if the 2025 reset was a durable trend or a fleeting rally. Three key catalysts will provide that clarity.

First, the immediate risks are geopolitical and energy-driven. The market must monitor oil prices and the resolution of Middle East tensions. The recent spike to around $80 a barrel and the conflict in Iran have disproportionately hurt international equities, as noted by J.P. Morgan's strategist. If tensions escalate or oil stays elevated, it will pressure earnings in energy-dependent economies, reinforcing the current underperformance. A swift de-escalation and price stabilization would remove this direct headwind.

Second, the fundamental catalysts are the structural growth stories that were not fully priced in. Investors need to see concrete signs of Europe's fiscal stimulus, like Germany's big spending moves, and Japan's corporate restructuring effort translating into actual earnings growth in 2026. These are the long-term drivers that justify the valuation discount. Positive economic data from these regions would validate the optimism and support a new, higher baseline for international stocks.

The ultimate signal for a new normal is performance. The market will watch to see if international stocks can resume outperforming the S&P 500 on a sustained basis. The current baseline is telling: the Vanguard Total International Stock ETF (VXUS) is up 9% year to date, while the S&P 500 is essentially flat. This lead is fragile. For the shift to be durable, international equities need to hold this advantage through volatility, proving they are no longer just a geopolitical casualty but a structural winner. The recent three-day outperformance by the S&P 500 against international stocks is a warning shot. Sustained leadership from overseas is the only way to close the expectation gap for good.