New roads to returns in 2025: Look to small-to-mid caps and dividend stocks
Increasing divergence in policies, economic performance, and geopolitics presents a strong range of opportunities for market participants
WHAT a year 2024 turned out to be. At the start of the year, investors and strategists braced for a potentially turbulent 2024, worrying about the risk of a recession for the US economy amplified by overly tight financial conditions.
The recession never came; economic data remained resilient; and equity markets’ annual gain would be among the best in history. In fact, at the start of December, US markets notched their 56th closing record this year while global equities also hit an all-time high.
Underneath the surface, there was another dynamic taking place. Breadth in the market was widening. The rest of the market is starting to join previous market leaders in their upward march.
However, the year ahead promises a different environment for financial investors. A landmark US election, rising stimulus in China, and growing geopolitical tensions mean 2025 and beyond will be markedly different from what we’ve seen so far.
Across markets, we are noticing an increasing divergence in policies, economic performance, and geopolitics. This also presents a strong range of opportunities for market participants in 2025. However, investors will need a different playbook from what worked well in the first half of the 2020s.
Opportunities in 2025
From an economic standpoint, growth-supportive policies from the incoming US administration bode well for US domestic economic growth. The Fed is also expected to continue its interest rate cutting cycle at least through early-to-mid 2025, which will also support growth. Accordingly, other major economies will work to navigate the shift in US policies.
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China, while still on its quest for a more sustainable model of growth, will probably also focus on providing policy support to areas of weak domestic demand and to offset pressures that could arise from increasing tariffs.
The developments amount to an encouraging backdrop for equity and credit markets, even if they promise turbulence too. Among asset classes, equities look appealing thanks to a backdrop of economic growth, policy support and corporate earnings growth. However, given significant policy changes ahead, investors should remember to stay selective.
It is also important to be discerning when it comes to industries that have done well over the past two years, especially where investor crowding and expectations remain high.
US mega-cap tech stocks are one such example. Looking beyond well-owned mega-caps and obvious artificial intelligence (AI) winners, having exposure to unappreciated winners who will be vital parts of the AI value chain in the future such as IT consultant companies, or adopters of technology such as industrial companies looking to digitise processes, could offer interesting opportunities.
Valuations in these areas are also much less demanding.
On the other hand, segments that could benefit from a continued broadening of the rally hold better potential.
One such area is small-to-mid caps. They avoid the higher valuations of mega-cap stocks, while potentially benefiting from late-cycle reflation and falling interest rates. Their valuations also remain attractive relative to history and to large mega-caps.
Another interesting area is quality dividend stocks. Not only could they benefit from the broadening of the rally as investors increase exposure to value and defensive stocks, but they also tend to gain more investor attention as interest rates decline.
Certain Asian stocks also offer opportunities after years of weaker returns. Asian dividend stocks, which currently have average dividend yields in excess of 5 per cent, offer exposure to structural growth trends. China stocks where valuations are still below long-term averages also offer interesting prospects.
However, investors should be selective and focus on areas that offer higher dividends and are more domestic-orientated or are high on the government’s policy agenda.
For income investors, easing policy and higher yields in investment-grade bonds provide yield pickup and participation in global interest rate cuts, especially in markets outside the US.
Closer to home, while Singapore looks relatively attractive, it remains concentrated in cyclical sectors such as banks, real estate investment trusts and industrials, with little to no exposure in high-growth sectors such as tech, consumer and the like.
Allocating some exposure to global markets allows diversification across markets and non-Singapore-dollar currencies, and participation in global growth trends unavailable in local markets.
As the global interest rate cut cycle continues, yields on fixed deposits and T-bills in Singapore dollars are likely to continue falling. Global high-quality bonds could offer yield pick-up and diversification from equities in portfolios.
Preparing for unexpected outcomes
While it is clear earnings in many areas will improve in 2025 and the global mood is positive, there are still risks on the horizon – the biggest being the crowded consensus views and valuations.
Growth, inflation and interest rates across the world’s biggest economies are liable to head in very different directions in the months ahead, and investors should stay vigilant and mindful of unexpected negative surprises.
One way to protect against unexpected economic trip-ups and geopolitical risks could be to diversify portfolios through US duration and higher-quality fixed income. The risk-reward is relatively attractive at current yield levels and they also offer diversification from equities, as they tend to hold up much better in bouts of volatility.
Another way to mitigate risks is to broaden one’s exposures beyond the winners of past years. Going into 2025, while valuations of large caps in the US are close to multi-cycle highs and susceptible to disappointments, the rest of the market is starting to catch up and are trading at more reasonable levels just as their earnings are starting to grow. These present good opportunities for investments that could deliver solid returns in the medium to long term.
At the height of the Cold War, academic and US senator J William Fulbright once said there is an inevitable divergence between the world as it is, and the world as man perceives it. Investors will need a flexible approach. Detailed, deep research into the businesses and markets they invest in will be at a premium. Divergence, as Fulbright said, is inevitable – and this year it will pay to watch the differences.
The writer is client portfolio strategist, Fidelity International
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