Entering 2025, we pinpointed several critical fault lines and promising updrafts for financial markets. The year has been a rollercoaster, and it's no surprise that both challenges and opportunities have emerged, leaving us with an outlook that's equally optimistic and cautious.

The key questions we posed at the start of the year remain as relevant as ever. And just as we did in our mid-April update, we revisit those questions here, leveraging the latest readings of State Street’s investor behavior metrics. In the process, we explore the topic of “United States exceptionalism.” Will it continue to dominate market consensus, or are we on the brink of a significant rebalancing?

Allocations are back to peak optimism. Investors entered 2025 with a high allocation in equities relative to bonds. Over the past 25 years, the average allocation to equities has been around 20 percent above the allocation to fixed income, in line with a 60/40 portfolio approach. In January, it peaked at 7.5 percent above this long-run average, reaching a 15-year high.

While this overweight more than halved during the turbulent three months that followed, investors never really gave up on equities. This sentiment was reinforced by the rapid rebuild of the equity overweight, nearly reaching its January high by the end of July. This brings us back to the question we asked at the beginning of the year: Will the earnings and economic outlook justify such a risk-seeking allocation to equities?

Federal Reserve easing cycles usually coincide with a double-digit reallocation out of equities back to bonds. Once again, this cycle is proving to be different. Optimists will point to the rapid rebound in equity sentiment after its first quarter slip as another demonstration of the resilience of equity fundamentals. However, this also means that vulnerabilities to the outlook have returned. As seen in Figure 1, asset manager allocations to equities are stretched once again to levels seen only in the run-ups to August 2000 and July 2007, which are troubling precedents even if this time is different.

The answer to the question we posed at the start of the year, “Will the US remain exceptional?” is a definitive yes! Investors are overweight equities as discussed above, but within equities, the only overweight across regions is still the US.

By the end of March, investor holdings of US stocks above benchmark weight had been reduced by around one fifth, and there was a flirtation with above-benchmark holdings in European stocks. But this proved brief: By July, holdings in US equities had begun to rise again modestly.

US holdings are still lower than they were at the beginning of the year, and so underweights in Europe, the United Kingdom and emerging markets are also all a little smaller. So one could argue that the US, from an equity viewpoint, is a little less exceptional than it was in December, but only marginally so, as shown in Figure 2. The fact that US equities remain the only region where investors are willing to retain a significant overweight, in spite of all the geopolitical and policy uncertainties in 2025, highlights the resilience of this view.

As State Street Markets’ head of Equity Research, Marija Veitmane argued back in January, it is a view supported by robust relative earnings growth, and this was once again borne out by a strong second-quarter earnings season, especially in tech. US equity exceptionalism remains a well-earned narrative.

While investor sentiment toward US equities has been robust, the same cannot be said for US Treasuries. After a volatile first four months, 10-year yields have been stuck around 4.3 percent. Despite reduced US growth expectations, inflation expectations have risen due to anticipated tariff impacts on consumer prices, which we can track using PriceStats® data. The US budget bill has also locked in significant fiscal stimulus and increased Treasury supply.

Against this mixed backdrop for Treasuries, asset manager demand has been tepid, especially among international investors and for longer-dated bonds. This trend isn't new; as shown in Figure 3, foreign asset manager demand for Treasuries has been below average for a year. Conversely, there's been a recovery in foreign demand for German and Japanese government debt. This reinforces our earlier point: Demand for US equities is exceptional and not mirrored by sovereign fixed-income investors.

The question now is whether the US dollar depreciation can go any further. The US dollar depreciated by almost 10 percent in the first seven months of 2025, marking its worst start to a year in over two decades. This move occurred despite interest rate differentials not justifying such weakness. Our analysis points to two main factors: the rise in policy uncertainty, which has sapped US dollar strength, and the dramatic change in asset manager hedging activity over the past nine months.

On this latter point — and in contrast with the behavior observed in the Treasury market — the change has been led by US-based investors. For fixed-income managers based in the US, the fear of a rapid US dollar appreciation following the US Presidential election manifested itself in a surge in forward US dollar buying that took their hedge ratio on their foreign bond holdings to a  nearly 80 percent, a 25-year high.

This ratio peaked in mid-January and as the feared US dollar overshoot failed to materialize, US managers sold their US dollars forward rapidly to bring their hedge ratio back down below 60 percent, where it has finally consolidated in July, close to its long-run average. This part of the sentiment change would seem therefore to be done. Indeed, in July we even saw some signs of recovery in domestic demand for the dollar.

However, not all investors have adjusted to the US dollar’s weaker trend. Non-US investor hedge ratios on their US equity holdings remain unusually low. This means that for all the exceptional foreign buying of US equities in the past five years, there have been relatively fewer forward sales of the US dollar to offset the currency risk.

This is largely understandable, as typically during this period, the US dollar has offered a natural hedge to equities. Generally when equities have declined, the US dollar has appreciated given its empirical safe-haven status. But this relationship has been challenged so far in 2025. The US dollar has depreciated alongside equity market declines. This may alter the view that non-US investors should maintain such a low hedge ratio on their US equity exposures, and is one area we are watching closely in the second half of the year for a potential continuation of forward US dollar sales from asset managers. So in contrast to US equities, it has been the weakness of the US dollar — driven by the change in investor attitude toward it —  that has been exceptional (see Figure 4).

After a highly uncertain eight months, US equity dominance — particularly in tech — remains largely unchallenged. Investor sentiment and fundamental metrics both support this view. US exceptionalism is alive and well, but it's increasingly concentrated in US equities. Alternatives in other regions or asset classes still lack the fundamentals to mount a serious challenge.

The view through other asset classes is much less sanguine. The lack of foreign demand for long-dated Treasuries remains troubling, and investor hedging of the US dollar has shifted abruptly against the currency for much of this year, even though interest rate differentials have remained in its favor. Both behaviors point to a more cautious outlook as the impact of economic and policy uncertainties in the US and elsewhere continue to unfold.

Looking ahead to the remainder of 2025 — with the US budget set, trade policy beginning to crystallize and the interest rate path potentially clearing — policy uncertainty may start to decline. Media focus on this topic has already begun to edge lower over the summer. This in turn may help to alleviate investor concerns about Treasuries and the US dollar. Domestic investor demand for both is already showing signs of recovery.

But it remains early days. The true economic impact of policy changes will take some time to play out fully, even in real-time data such as PriceStats. Against this backdrop, such high investor allocations to equities implies a significant vulnerability to much weaker economic news if it eventually comes.

Finally, if uncertainty does indeed subside in the remainder of 2025, we will then begin to get answers to fundamental questions: Were reassessments of the US dollar and Treasuries tactical blips in contrast with the resilience of equity holdings? Or were they the beginning of a more structural shift out of these US assets?