Strategic Allocation in a Diverging World: Leveraging Non-US Equities and High-Yield Bonds for Stagflation Risk Mitigation

In a world where global economic cycles are diverging and policy uncertainty looms large, investors must rethink traditional asset allocation strategies. The second quarter of 2025 has delivered a stark reminder: non-US equities and high-yield bonds are no longer niche bets—they are linchpins of a resilient portfolio. Fidelity's Q2 insights paint a clear picture: as the U.S. dollar weakens and stagflationary pressures mount, diversifying into non-US assets and risk-on sectors offers a compelling hedge against both macroeconomic and policy-driven risks.

A Dollar Weakness-Driven Rally in Non-US Equities

The U.S. dollar's three-year low has been a tailwind for non-US equities, with Latin America (+15.2%), Canada (+14.2%), and Emerging Asia (+12.4%) leading the charge. This surge is not a fluke. A weaker dollar makes foreign assets cheaper for U.S. investors and boosts corporate earnings for multinational firms in regions with appreciating currencies. For example, European and Japanese equities (both up 11.4% in Q2) benefited from improved earnings visibility and a shift in global capital toward undervalued markets.

Fidelity's overweight position in non-US equities is rooted in this dynamic. With U.S. stock valuations trading at multi-decade highs, the valuation gap creates a natural gravitational pull toward markets offering better risk-adjusted returns. The dollar's role as a global reserve currency is also under strain, with central banks diversifying reserves into euros, yuan, and other currencies—a structural shift that could prolong the outperformance of non-US assets.

High-Yield Bonds: A Counterintuitive Play in a Stagflationary World

While high-yield bonds are typically seen as a cyclical bet, their Q2 outperformance (3.6% returns) underscores their role as a stagflation hedge. Credit spreads tightened to historical lows, driven by a rebound in market sentiment after U.S. tariff announcements and a recovery in corporate credit fundamentals. Fidelity's focus on high-yield bonds as part of a diversified fixed-income strategy is particularly prescient: these bonds offer income generation in a low-yield environment while providing exposure to companies poised to benefit from global economic expansion.

The real kicker? High-yield bonds' performance is less correlated with U.S. interest rates than commonly assumed. While 10-year Treasury yields lingered near 4.2%, the broader fixed-income market's 50th percentile valuation suggests that high-yield bonds are priced for a moderate, not catastrophic, macroeconomic outcome. This makes them an ideal complement to non-US equities in a stagflationary scenario, where traditional safe-haven assets like gold and TIPS also play a role.

Navigating the Diverging Global Cycle

Fidelity's Q2 positioning reflects a nuanced understanding of diverging global cycles. While the U.S. grapples with policy-driven volatility (tariffs, immigration reforms), economies in Europe, Canada, and China are showing signs of synchronized growth. This divergence is not just a temporary phase—it's a structural shift.

For investors, the lesson is clear: underweighting U.S. assets in favor of non-US equities and high-yield bonds is no longer a defensive move—it's a proactive strategy. Here's how to implement it:
1. Overweight non-US equities: Focus on regions with strong earnings momentum and undervalued currencies (e.g., Emerging Asia, Latin America).
2. Allocate to high-yield bonds: Prioritize sectors with pricing power (e.g., energy, industrials) and geographic diversification.
3. Hedge with gold and TIPS: These assets provide insurance against inflation and currency devaluation.

The Bigger Picture: Policy Uncertainty as an Opportunity

The U.S. policy environment—marked by aggressive tariff hikes and regulatory uncertainty—has created a self-fulfilling prophecy: investors are fleeing overvalued U.S. assets and seeking yield elsewhere. This trend is unlikely to reverse unless the dollar rebounds, which would require a synchronized global slowdown—a scenario Fidelity itself deems unlikely.

In this context, non-US equities and high-yield bonds are not just diversifiers—they are core portfolio components. They offer exposure to growth engines outside the U.S. while mitigating the risks of a policy-driven stagflationary environment.

Final Thoughts

The Q2 2025 data is a call to action. As global cycles diverge and policy uncertainty intensifies, investors must reallocate capital to where value and growth are most pronounced. Non-US equities and high-yield bonds are no longer peripheral—they are central to a forward-looking portfolio. By embracing these asset classes, investors can navigate stagflation risks, capitalize on dollar weakness, and position themselves for the next phase of the global economic cycle.

Investment Takeaway: In a world of diverging cycles, the key to resilience is diversification. Overweight non-US equities and high-yield bonds today—before the market fully prices in the next phase of global economic realignment.