Amid divergent trends, opportunities arise in small/mid-cap equities and quality income
As markets evolve, investors should not only focus on today’s leaders but also identify the regions and sectors next in line to benefit
EQUITY markets saw an exciting start to 2025, with developments ranging from the new US administration’s policy shifts to DeepSeek’s new AI open-source model, which challenged previous assumptions about demand for artificial intelligence.
While markets managed to regain their footing and recover most of the losses, announcements of new tariffs by the US sparked renewed volatility across global stock markets.
So far in mid-February, global markets have delivered mixed performances, setting the tone for a pivotal year ahead.
The US, China and Europe are moving in distinct directions, driven by varied concerns across policy, economy, and geopolitics. This divergence may seem complex, but it also unlocks fresh opportunities for investors who know where to look.
It’s safe to say that we are in an environment that calls for a new playbook, fresh thinking, and the agility to continually adapt. Going into the Year of the Snake, the path ahead promises divergence – across countries, asset classes and sectors. Investors should stay diversified but also be nimble and ready to strike when opportunities arise.
Reflation in the US
There is confidence that the US administration will roll out pro-US business, pro-growth and pro-innovation policies. The resulting reflation should support equity earnings and ease concerns over higher valuations.
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Opportunities reside in many areas such as technology, where structural trends underpin the long-term outlook, and small to mid-cap stocks, which tend to be sensitive to domestic growth.
The current macro environment also sets the stage for risk assets, especially stocks, to thrive. In the coming year, opportunities will likely broaden.
Over a third of the S&P 500’s value remains concentrated in the “Magnificent Seven”, which have led the pack in both earnings growth and stock performances for the second consecutive year in 2024. While these trends may have further to run, we anticipate a broadening rally as valuations and earnings growth of the rest of the market try to catch up.
Key sectors that could participate in the rally include tech stocks outside of the Magnificent Seven, defensive and dividend stocks, and certain non-US regions such as Asia. Each of these areas could see more investor interest.
As markets evolve, investors should not only focus on today’s leaders, but also identify the regions and sectors next in line to benefit.
Sweet spot in small/mid-cap stocks and high-quality income
Small and mid-cap stocks look attractive relative to mega-caps, as their earnings growth potential remains strong, fuelled by expectations of a resilient US economy and falling interest rates. Given their larger exposure to domestic sources of revenue, these companies may also be less impacted by any increase in tariffs.
We’re also seeing increased mergers and acquisitions activity, as potential policy shifts create opportunities in this segment. But selectivity is key. We prefer companies with strong fundamentals and industries often overlooked by the broader market.
High-quality income plays an important role in portfolios; dividend stocks are a powerful strategy for equity investors looking to maintain a level of stability and income. Dividend stocks tend to be found in sectors such as consumer staples, utilities, and non-life insurance, among others. They often outperform during market corrections due to their income buffer and their generally defensive profiles, enabling investors to ride out volatility.
On top of that, the potential broadening of the market rally and risk of a US recession appears underpriced in these dividend stocks. Hence, developments in either direction could potentially benefit the stocks.
Shelter from potential storms
2025 is ripe with opportunities, but it is not without risks. While the most recent headline US economic data looks strong, there are underlying nuances pointing to cracks in certain areas.
If growth deteriorates, the US Federal Reserve may be forced to take more aggressive action. In this environment, defensive, high-quality US investment grade bonds could potentially be a safe haven. Additionally, such bonds have historically proven to hold up much better in pockets of volatility, providing diversification benefits. Locking in yields now may also be a prudent move to shelter against falling interest rates.
Asian investment-grade bonds are also an appealing asset class for investors who seek exposure to Asia. We believe there are two key areas in terms of return drivers in the first half of 2025 – the Fed and China.
Rate cuts by the Fed could benefit the region, and China’s continued economic stability will support investment-grade issuers. The supply of Asian US investment grade bonds has also shrunk significantly in recent years while investor demand remains high, creating a favourable supply-demand dynamic.
One thing is clear: In today’s divergent landscape, it is important to shed old assumptions and embrace new opportunities. Overconcentrating on past winners is a risk; valuations matter now more than ever. Rather than overpay for growth, it’s essential to focus on quality opportunities.
To navigate this new environment, balance is crucial. A mix of growth and defensive assets creates a resilient portfolio, which can adapt to market shifts. The global situation remains fluid and will evolve, which is reflected in current market valuations. Staying diversified and nimble are key to investing in 2025.
The writer is client portfolio strategist, Fidelity International
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