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Clear tailwinds are gathering behind equity markets, providing an upbeat outlook for stocks in 2025.

The US economy remains strong, boosted by healthy labour markets, surging business investment and strong profit growth. The US Federal Reserve (Fed) 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 US, 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 recognised areas like AI, but also seeking opportunities in less scrutinized areas of the market.”

A mix of opportunities and risks

Elevated valuations are not 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 may include a mix of tailwinds and headwinds. On the plus side are proposals for tax cuts, increased defence spending and deregulation across a range of businesses, including banks, as well as energy, aerospace and health care companies.

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 opportunity 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 $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 is 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 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, an equity portfolio manager. “Because it can take on a multitude of human tasks, I consider the AI market to be unknowably massive.”

In the near-term, there will likely be overcapacity and excesses as enterprises experiment with AI to determine how to use it for competitive advantage. What’s more, 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, an equity portfolio manager.

“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 will be a much longer and slower build.”

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 giants 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 says. “That should provide investment opportunity for years.”

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 in the US, has provided significant opportunity for companies far beyond the tech sector. And that potential is being recognised. 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.

Conditions appear supportive for this broadening to continue, with the Fed easing monetary policy and the potential for more favorable regulations among banks, energy and health care companies, as well as likely increased defence spending under the incoming Trump administration. The US Commerce Department in November tapped global defense contractor BAE Systems to provide semiconductors used in jets and satellites, for example.

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, long-term trends such as the relocation of manufacturing to the US and AI data centre construction will boost electricity demand. For example, CenterPoint Energy is forecasting strong growth in 2025 due to booming demand for electricity and natural gas in Texas.

“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 defense 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 capitalisations of roughly $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 centers, 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 US

The wave of trends laying the foundation for a capital spending super-cycle in the US 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 center 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 Lara Pellini, an equity portfolio manager. “Europe is home to industrial powerhouses solidifying their foothold in areas ripe for potential long-term global growth.”

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 for investors, 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.”