Investor Preferences Shift: International Stocks and Treasuries Outperform as U.S. Small Caps Retreat

The investment landscape in 2025 has been defined by a dramatic reallocation of capital, driven by macroeconomic shifts, policy uncertainty, and evolving risk appetites. As global markets grapple with a weaker U.S. dollar, a steepening Treasury yield curve, and divergent regional growth trajectories, investor preferences have crystallized around three key themes: the resurgence of international equities, the renewed appeal of U.S. Treasuries, and the relative underperformance of U.S. small-cap stocks. These trends are not just reshaping asset classes—they are redefining how investors approach diversification, duration, and risk management in an increasingly fragmented world.

The Rise of International Equities: A Structural Shift

International stocks, particularly in emerging markets, have dominated global capital flows in 2025. The U.S. Dollar Index (DXY) fell sharply in the first half of the year, marking its steepest decline in nearly four decades. This depreciation acted as a tailwind for non-U.S. investors, boosting returns for U.S. investors in international equities by reducing currency headwinds. Emerging markets, in particular, surged 30% year-to-date, outpacing U.S. large-cap stocks, which gained just 7.9% in Q3 but lagged for the full year.

The outperformance is rooted in both fundamentals and valuations. Europe and Asia have seen fiscal stimulus, AI-driven productivity gains, and improving corporate earnings, while U.S. markets remain elevated on valuation metrics. For example, the MSCI EM Index traded at a 30% discount to the S&P 500 in early 2025, making it an attractive destination for capital seeking growth. Meanwhile, U.S. trade policy uncertainty and fiscal deficits have pushed investors toward more dynamic economies.

U.S. Treasuries: A Safe Haven in a Volatile World

While equities have captured headlines, U.S. Treasuries have quietly become a cornerstone of risk management strategies. The Treasury yield curve steepened dramatically in 2025, with short-term rates falling as the Federal Reserve cut interest rates in response to a weakening labor market and subdued inflation. Long-term yields, however, edged higher due to concerns over U.S. fiscal sustainability and trade policy risks. This divergence has created a unique environment where investors are extending duration in fixed income while hedging against inflation with TIPS (Treasury Inflation-Protected Securities).

The appeal of Treasuries is further amplified by their role as a liquidity backstop. With global investors holding nearly $20 trillion in cash and short-term instruments, Treasuries have become a critical tool for managing portfolio volatility. However, the allure is not without caveats. Rising U.S. deficits and the erosion of real yields (which turned negative in 2025) have prompted a shift toward shorter-duration bonds and alternative fixed-income assets, such as international sovereign debt.

U.S. Small Caps: A Tale of Two Halves

U.S. small-cap stocks, once a darling of the Fed's dovish policy, have struggled to maintain momentum. While they posted a 12.3% gain in Q3—outpacing U.S. large-cap stocks—they underperformed international equities for the full year. The sector's challenges stem from a combination of weak profitability and a “junk rally” dynamic, where lower-quality, debt-dependent small-cap firms outperformed higher-quality names. This trend, while buoyed by low interest rates, raises concerns about sustainability.

The underperformance highlights a key tension in 2025: the Fed's rate cuts have disproportionately benefited small-cap stocks, which are more sensitive to interest rate changes. However, as global investors pivot toward international markets and alternatives, U.S. small caps face a dual headwind—higher competition for capital and structural weaknesses in earnings growth.

Implications for Asset Allocation: Diversification and Duration

The 2025 capital flow trends underscore a broader shift in asset allocation strategies. Investors are recalibrating portfolios to balance growth, income, and risk. Here are three key takeaways:

1. Global Diversification is Non-Negotiable: The outperformance of international equities has forced a reevaluation of traditional 60/40 portfolios. Investors are increasing exposure to non-U.S. markets, particularly in Asia and Europe, to capture growth and reduce reliance on U.S. dollar-based assets.

2. Duration Management in Fixed Income: The steepening yield curve has created opportunities for investors to extend duration in Treasuries while hedging inflation risks. However, the focus is shifting toward shorter-term bonds and inflation-linked securities to mitigate fiscal and geopolitical uncertainties.

3. Small Caps as a Complement, Not a Core: While U.S. small caps remain a part of many portfolios, their role is evolving. Investors are increasingly allocating to international small-cap opportunities, where growth prospects are stronger and valuations more attractive.

Conclusion: Navigating the New Normal

The 2025 market environment is a microcosm of a broader shift in global capital flows. As investors grapple with a weaker dollar, a steepening yield curve, and divergent regional growth trajectories, the winners and losers are becoming clear. International equities and U.S. Treasuries have emerged as key beneficiaries, while U.S. small caps face a reckoning. For investors, the lesson is simple: adaptability and diversification are no longer optional—they are essential.

In this new normal, the focus must be on building portfolios that can withstand macroeconomic volatility while capturing growth in a multipolar world. That means embracing international opportunities, managing duration carefully, and rethinking the role of small-cap equities. The markets of 2025 have made one thing abundantly clear: the days of U.S. exceptionalism in capital flows are over. The future belongs to those who look beyond the familiar.