by Julian Abdey, Mark Casey, Cheryl Frank, Equity Portfolio Managers, Capital Group
KEY TAKEAWAYS
- Solid U.S. economic growth provides a constructive environment for stocks.
- Companies connected to the AI build-out generate opportunity beyond the tech sector.
- Select opportunities are surfacing across dividend payers and small caps.
Clear tailwinds are gathering behind equity markets, providing an upbeat outlook for stocks in 2025. The U.S. economy remains strong, boosted by healthy labour markets, surging business investment and strong profit growth. The U.S. Federal Reserve and other major central banks have initiated an interest rate cutting cycle, providing an additional tailwind for financial assets.
Against this backdrop, markets enter 2025 amid a post-election rally in the U.S., as investors focus on business-friendly initiatives of the incoming Trump administration. And while advances in artificial intelligence continue to get most of the headlines, participation in the market rally has quietly broadened across industrials, utilities, health care and other sectors, as well as small-cap companies.
“Valuations generally are quite elevated,” says Julian Abdey, an equity portfolio manager. “So I’ve been trying to strike a balance in portfolios, looking for exposure to leading companies in well recognized areas like AI, but also seeking opportunities in less scrutinized areas of the market.”
A mix of opportunities and risks
Elevated valuations aren’t the only risk investors must consider in 2025. Sluggish economies in Europe and China could weigh on prospects for some companies, and ongoing conflicts in Ukraine and the Middle East could agitate markets.
President-elect Trump’s priorities, while generally well received by investors, may include a mix of tailwinds and headwinds. On the plus side are proposals for tax cuts, increased defense spending and deregulation across a range of businesses, including banks, as well as energy, aerospace and health care companies.
“Trumponomics” could produce tailwinds and headwinds across the economy
Source: Capital Group. As of November 30, 2024. Examples listed are for illustrative purposes only and do not represent investment recommendations.
Other Trump policies present challenges for certain industries. Plans for tariffs could trigger protracted trade conflicts with the country’s top trade partners — and potentially reignite inflation. The administration also will likely seek to roll back or dilute subsidies for renewable energy and electric vehicles. And deportations and immigration restrictions could potentially drive up labour costs, putting pressure on profit margins.
“There will be winners and losers, but many of these policy priorities are complex, and their impact is not always clear,” Abdey says. “The saying goes that ‘personnel are policy,’ so the appointments will be critical in driving policy outcomes. In the meantime, I am focused on trends driving growth opportunities and identifying companies that can best take advantage of those opportunities, whether fast-growing tech businesses, old economy companies in cyclical sectors or traditional value sectors, like utilities.”
AI may be overhyped, yet bigger than you think
Excitement over the transformative potential of AI remains sky high, as does investment in the technology. Tech giants Amazon, Alphabet, Meta and Microsoft are expected to collectively spend US$500 billion over the next three years in a race for dominance. The aggressive spending has been compared to excessive internet investments in the late 1990s amid questions about a possible AI pullback on the horizon.
The excitement and the concerns could both be valid. That’s because we tend to overestimate mega trends in the short term while underestimating them over the longer term. Consider that early estimates for the size of personal computer, mobile phone, internet and cloud computing markets combined fell short by an average of 38%. Could AI market estimates fall even shorter?
“What is remarkable about AI is its broad potential utility,” says Mark Casey, equity portfolio manager. “Because it can take on a multitude of human tasks, I consider the AI market to be unknowably massive.”
We tend to overestimate the short term and underestimate the longer term
Source: Morgan Stanley AI Guidebook: Fourth Edition, January 23, 2024. Actual totals are as of 2000 for PC and internet users; 2013 for smartphone shipments; and 2020 for cloud provider revenue. Values in USD.
When and where will the multibillion-dollar AI spending spree pay off for investors?
The answer lies in the four-layer technology stack that enables AI workloads, as well as the supply chain needed for AI infrastructure. The AI stack includes semiconductors, cloud infrastructure, large language models such as Chat GPT, and applications for end users. Chipmakers like NVIDIA and ASML operate at one level while tech titans like Alphabet, Microsoft and Amazon seek to dominate multiple layers.
“There will be successful companies at each layer of the stack, and certain companies are trying to launch successful products at two or even three layers,” Casey says. “The question is, which companies will execute best — and which will stumble. That’s what I am focused on.”
But the new technology also relies on old economy resources, including copper, capital equipment and power. Soaring demand for these resources has been a boon for utility, industrial and mining companies. “The four so-called hyperscalers — Alphabet, Amazon, Meta and Microsoft — are spending about half of their capex budget on technology and half on buying land, constructing as many data centres as possible near reliable power and locking in long-term contracts with energy suppliers,” Casey adds. “That should provide investment opportunity for years.”
The soaring demand could lead to shortages and some bottlenecks in the data centre build-out. "There may not be enough power capacity, basic materials or capital equipment available for AI expansion to happen as quickly as many expect" says Cheryl Frank, equity portfolio manager.
On the other hand, the unprecedented demand could lead to areas of excess. There are many deep-pocketed players who are trying to secure supply of chips in a capacity-constrained market. Capacity constraints and urgency often create double ordering and false demand signals, Frank explains. If the return on investment on this spending turns out to be inconsistent or low, the demand profile could change quickly.
“I think there will be two AI cycles,” Frank says. “Now we are in the middle of an advertising-driven consumer AI cycle, and there will likely be a pullback. But the enterprise AI cycle, when businesses broadly adopt AI within their processes, will be a much longer and slower build.”
Market gains have recently extended beyond tech
Sources: Capital Group, FactSet. As of November 30, 2024. Returns are in USD.
Forgotten corners of stock market showing life
Indeed, the AI build-out, along with other major trends such as the rollout of electric vehicles and reshoring of manufacturing to the U.S., has provided significant opportunity for companies far beyond the tech sector. And that potential is being recognized. Market participation broadened beyond the tech sector in the second half of 2024, as dividend payers, value-oriented stocks and small caps all outpaced the broader S&P 500 Index.
Conditions appear supportive for this broadening to continue, with the U.S. Fed easing monetary policy and the potential for more favourable regulations among banks, energy and health care companies, as well as likely increased defence spending under the incoming Trump administration. For example, with regard to defence spending, the U.S. Commerce Department in November tapped global defence contractor BAE Systems to provide semiconductors used in jets and satellites.
Less regulation and the potential for lower corporate tax rates could strengthen free cash flows for a range of dividend-paying companies, enabling them to boost payments. In addition, the combination of long-term trends such as the relocation of manufacturing to the U.S., AI data centre construction and electric vehicle demand are driving unprecedented demand for electric power in the U.S. For example, CenterPoint Energy is forecasting strong growth in 2025 due to booming demand for electricity and natural gas in Texas.
A less-strict antitrust environment could spark more mergers and acquisitions activity within health care.
Within the pharmaceuticals industry, Frank says she is finding a number of inexpensive pharma companies that have been ignored amid the market focus on glucagon-like peptide-1 (GLP-1) weight loss drugs.
“I am looking for opportunities to invest in dividend payers that have been left behind by the market,” says Frank. “These include forgotten pharma, or drugmakers that don’t offer weight loss treatments, as well as utilities and select banks and defence companies.”
Big market trends extend opportunity to small caps
Several trends driving opportunity for the largest companies are also doing so among small-cap companies, or businesses with market capitalizations of roughly US$6 billion or less. For example, Comfort Systems, a maker of heating and ventilation systems, and Modine Manufacturing, which builds cooling systems essential for data centres, have seen demand soar.
While mega-cap tech stocks dominated market returns over the last few years, small-cap companies have been trading near their cheapest valuations in more than 20 years relative to large companies.
“The valuation disconnect between small and larger stocks is one of the highest we’ve seen,” Abdey says. “There are a lot of innovative companies reasonably priced relative to larger companies associated with well-known market themes. I believe certain small caps are poised for a comeback.”
Capital spending super-cycle extends beyond U.S.
The wave of trends laying the foundation for a capital spending super-cycle in the U.S. is also driving opportunity for nimble European industrials.
Air travel is now above pre-COVID levels, driving demand for new commercial aircraft. Airbus, one of only two major manufacturers of planes globally, has a backlog of orders stretching out a decade.
France-based Schneider Electric, a leader in the industry, has posted double-digit sales growth for the third quarter of 2024 from global data centre build-out, which is fueling demand for specialized equipment.
Within construction, a growing preference for durable materials that boost energy efficiency and lower costs has created opportunity for chemical makers such as Switzerland’s Sika. Operating in a fragmented market, Sika is looking to gain market share by using size and scale to its advantage.
“These trends represent multi-decade investment opportunities, and we are only in the early innings,” says equity portfolio manager Lara Pellini. “Europe is home to industrial powerhouses solidifying their foothold in areas ripe for potential long-term global growth.”
European industrial titans are looking beyond Europe for opportunity
Sources: Capital Group, FactSet. Revenue by region is estimated by FactSet based on most recently reported figures. As of November 30, 2024. Company examples cited are for illustrative purposes only and are not meant to be an investment recommendation.
Balance will be essential in the year ahead
There are clear reasons to be optimistic about equity investing in 2025. The artificial intelligence build-out, the advancement of life-changing medicines in the health care sector and a global capital investment super-cycle are just a few trends driving opportunity for well-run companies across the economy. There are, however, risks, including the lofty valuations of many stocks and the potential for disruptive trade conflicts.
The key, says Frank, is to invest selectively with a long-term focus and maintain balance in portfolios. “I think it is important to stay fully invested, but I am pursuing diversification and trying not to be overexposed to any specific trend.”
Julian Abdey is an equity portfolio manager with 28 years of investment industry experience (as of 12/31/2023). He holds an MBA from Stanford and an undergraduate degree in economics from Cambridge University.
Mark Casey is an equity portfolio manager with 23 years of investment industry experience (as of 12/31/2023). He holds an MBA from Harvard and a bachelor’s degree from Yale.
Cheryl Frank is an equity portfolio manager with 26 years of investment industry experience (as of 12/31/2023). She holds an MBA from Stanford and a bachelor’s degree from Harvard.
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