February 2025 Active Management Insights: Increased global opportunities in small caps

Executive summary:

• Managers see U.S. banks and financials as likely to benefit from the new U.S. administration’s expected looser regulatory stance, which they believe will lead to an uptick in mergers and acquisitions. There is much greater uncertainty among managers on how potential U.S. tariffs could impact various sectors and regions. 
• The ongoing demand for AI and the need for infrastructure to support it is causing managers to add to opportunities in the utilities sector. Interest in the energy sector is also on the rise.
• Managers see mixed opportunities in emerging markets and a broadening opportunity set for small caps across global markets.

U.S. election impact: Sorting through the noise and information flow

• There is general agreement among investors that financial deregulation and decreased antitrust intervention will boost M&A (merger and acquisition) activity. U.S. banks and financials are expected to benefit, as well as smaller cap stocks that are likely to be acquisition targets.
• Managers also anticipate that the second Trump administration will extend tax cuts and reduce corporate taxes, expecting these changes to support greater consumer spending and business activity. That said, investors are less certain about the magnitude and impact of tariffs. While most expect a more protectionist trade stance, there continues to be a great deal of uncertainty regarding the magnitude of tariffs applied across industries and trading partners. Globally, managers are favoring companies that benefit from U.S. onshoring and reducing exposure to exporters to the U.S., while being mindful of over-responding to rhetoric.
• In addition to tariffs, tighter immigration policy is contributing to concern about a resurgence in inflation, as a reduction in the low-cost workforce has the potential to drive labor costs higher.

Mixed opportunities across emerging markets (EM)

• The Chinese government’s support of the property sector has helped to stabilize prices and bolster consumer confidence. Managers are seeking opportunities in the Consumer sector and domestically oriented companies that do not have U.S. tariff exposure, while broader investor sentiment is mixed.
• The decline of the Indian equity market in Q4 has provided a buying opportunity for investors who continue to see positive long-term growth. Investors are focusing on opportunities in infrastructure, energy, and the energy transition space.
• Elsewhere in EM, investors are optimistic about Argentina after the country has curbed inflation. Views on Brazil are mixed with inexpensive valuations but also fiscal and monetary challenges. Similarly, sentiment on South Korea is unclear, as it’s critical to AI (artificial intelligence) infrastructure but under pressure due to political instability.

Global interest in utilities & energy

• Investors are selectively seeking opportunity in utilities, looking for companies that will benefit from the build-out of AI infrastructure and increased demand. Many utilities offer greater growth potential than they have historically.
• Globally, there is burgeoning interest in energy stocks with a rollback of U.S. green subsidies and valuation support.

Global opportunities for small caps

• Investors in multiple geographies are pursuing opportunities in small caps—including Europe, Japan, and the U.S. While specific drivers vary across markets, small cap versus large cap valuation spreads are attractive versus history, and small caps tend to be less dependent on global trade.

“America First” on investors' minds

• Managers believe that onshoring policies will benefit segments of U.S. manufacturing, particularly leading franchises within industrial automation and transportation with reduced import competition.

Selective opportunities among U.S. financials

• Managers think that U.S. President Donald Trump's inferred deregulatory stance, coupled with  slight eases in interest rates, will lead to a revival in M&A activity that had been delayed. Beneficiaries of this would include corporate finance providers and private equity owners.
• Conversely, global Value investors are wary of traditional bank lenders where potential credit shocks hurt earnings and high valuations.

Oil majors pick up the slack from renewables backtrack

• Tighter energy markets and the rollback of U.S. green subsidies will benefit higher spot prices and energy companies.

Bottom-fishing in weak cycles

• Value managers are taking advantage of the depressed consumer cycle within staples and hunting for strong global franchises.
• Both Value and Growth investors added to innovative GLP-1 drug producers, which had previously lagged owing to efficacy concerns that have since abated.

Alternative avenues and margin of safety

• Value investors are adding to European cash-yielding opportunities such as banks and autos as a diversifier to potential momentum unwinds. These businesses offer attractive dividends for downside support at depressed valuation levels and exhibit growth potential.
• Managers are also adding to stable emerging markets banks and insurance companies that enjoy above-average growth by increasing their footprint across unpenetrated markets.

Non-AI innovation

• Managers are bullish on continued growth in digital payments that demonstrate resilient earnings and higher return on capital.

The second Trump administration: Themes and market Implications

• Active equity managers across the board are seeking to digest what one manager called a ‘headline soup’ of floated regulatory and tax policies by the new administration and its affiliates to separate rhetoric from real intention and likely actions in office.
• On taxes and tariffs, managers expect expiring income tax cuts to be extended and corporate taxes to be cut, which should support consumer spending, corporate profits, and the broader market. New tariffs are expected to be enacted on an industry-by-industry basis, with most managers biding their time until there is a more complete picture of the relative competitive landscape.
• Regulation is expected to be reduced across multiple industries, with banks and other financials seen by managers as the most immediate beneficiaries. A reduction in net immigration is seen as more of a headwind, resulting in lower aggregate demand growth and higher wages, which could hit corporate profitability.
• Following four years of active intervention under the prior administration, antitrust policy is expected to be far more accommodating, leading to an increase in corporate M&A activity, particularly among smaller-cap companies.
• Though not evident in recent relative performance, healthcare companies are widely seen as beneficiaries under the new administration. Growth managers believe a lighter-touch FDA (Federal Drug Administration) bodes well for emerging biotech names, while value managers think the sector is the cheapest in the market.
• Energy policy is expected to encourage higher oil & gas production in the U.S. In combination with weakening demand growth from China (which is rapidly moving to hybrids/EVs) and the potential return of currently-sanctioned supply, the medium-term outlook for the oil price and consequently energy stocks is seen as broadly negative.

Consumer opportunities in China

• Investor sentiment remains mixed in China, but the government is demonstrating commitment to supporting the property sector and reviving consumer confidence. While uncertainty remains as to the adequacy of policy measures to stabilize prices and demand within the property market, investors are turning their attention to opportunities within the consumer sector.
• Domestically oriented companies are gaining attention amid rising geopolitical risks and uncertainty over potential U.S. tariffs.

Long-term optimism in India remains intact

• Slowing economic growth and weaker earnings led to a sharp market decline in Q4 2024. However, long-term optimism for the Indian market remains intact. While caution persists around valuations, some managers are taking advantage of the recent correction to explore opportunities within infrastructure, energy, and energy transition.

Potential for positive policy shifts in Brazil

• Within Brazil, investors prefer high-quality, defensive companies or businesses with less reliance on the domestic market, given fiscal and monetary challenges.
• Contrarian managers view valuations as highly attractive, with limited downside from current levels. Positive policy shifts could act as a catalyst for improvement, with President Lula da Silva’s intent to seek reelection in 2026 increasing the likelihood of such changes.

Political instability in South Korea

• South Korea remains critical to the AI supply chain. The market correction caused by political instability in December provided managers an opportunity to invest in semiconductor companies and secondary AI beneficiaries across the market cap spectrum.

Argentina to remain a bright spot

• Fiscal discipline has curbed inflation and fueled investor optimism that managers view as likely to be sustained. Investors see significant opportunities across banks and energy.

Persistent preference for defensives over cyclicals

• Defensive tilt continues: Hedge funds maintained a preference for defensive sectors in Q4, with continued buying in real estate, consumer staples, and healthcare, while trimming exposure to discretionary and energy.
• Sector adjustments: Increased allocations to utilities and health Care, while industrials and consumer discretionary saw reduced exposure.

Technology and momentum rotation

• Tech positioning stabilization: Net exposure to technology remains below historical averages despite a modest Q4 recovery.
• AI and cloud strength: Renewed interest in AI and cloud segments drove selective buying in high-growth areas.
• Momentum shift: Funds moved from high-beta plays to value-oriented strategies towards year-end.

Regional trends

• Europe overweight: U.S.-based hedge funds continued their overweight stance in Europe, driven by attractive valuations and easing inflation.
• China re-engagement: Renewed buying in Chinese equities, focusing on technology and consumer names following policy support.
• Japan outflows: Hedge funds turned net sellers of Japanese equities in December, capitalizing on earlier gains.

A turn in the road for small caps?

• European small cap valuations have derated relative to large caps to levels lower than seen during the GFC (Global Financial Crisis), on the back of growth struggles and political instability across Europe’s main economies. A falling yield environment tends to be positive for small cap stocks, while improved political stability can be a forerunner to an improved growth outlook. which depressed valuations do not currently price in.

UK utilities offer opportunity

• While regulated utilities in the UK have suffered in the face of rising yields given their perception as bond proxies, this can provide an opportunity to benefit in the long term from the sector’s attractive fundamentals. These companies offer attractive real yields and are well-positioned for growth given the opportunities provided by the UK’s investment needs in the areas of water or sewage. Meanwhile, the electrification required by the country’s stated objective of hitting net zero by 2050 will also demand considerable investment in copper-based infrastructure.

Is the market’s narrow focus coming to an end?

• Many managers are gradually reducing their exposure to top-cap value stocks in anticipation of greater market breadth. These stocks have achieved large gains over the past four years, driven by earnings recoveries, a weaker yen, and governance reforms.
• More managers are now reallocating proceeds into more diverse opportunities. These include:
  • Laggards within the same sectors, often smaller-sized companies.
  • Growth stocks that significantly underperformed with valuations that have become relatively more attractive.
  • Defensive stocks that underperformed in the past market rally.

Japan’s inflation expectations are continuously rising

• The persistent inflationary environment with solid wage growth is expected to benefit domestic demand-driven industries.
• Despite reducing holdings in financials due to past outperformance, many managers retain some exposure, anticipating a rise in interest rates to support these stocks further

Inflation expectations and defensive positioning

• While the soft-landing narrative remains intact in Canada, inflation concerns are rising among investors. Nominal wage growth, combined with concerns over U.S.-Canada trade tariffs, could pose inflationary threats.
• Managers are adopting a more defensive stance and, at the margin, adding exposure to the utilities sector, particularly to companies with combined utility and energy infrastructure assets. Increasing power demand from data centers provides an additional tailwind for some power producers.

Tariff-driven opportunities

• On the other hand, managers are exploring niche opportunities that could benefit in the event tariff threats materialize, such as logistics software.

Opportunities in communication services

• Telecommunication stocks lagged significantly in Q4 2024. Value-oriented managers are selectively adding to the defensive telecom names offering high dividend yields, viewing their valuations to be highly attractive.

Positive copper outlook

• Despite short-term volatility, the long-term outlook on copper remains strong, driven by supply constraints and demand from various industries, including EVs and renewable energy. Potential M&A activity within copper names could be a further tailwind.

Renewed optimism in banks

• Managers are turning more positive on banks as key drivers—loan volumes, margins, credit, and capital—are showing signs of improvement.

Cyclicals: Airlines and railways are attractive

• Valuation gaps between Canadian and U.S. airline stocks, despite comparable fundamentals, are attracting investor interest.
• The freight recession appears to be bottoming out, with pricing power and potential volume growth acting as key tailwinds.

Banks: Underweight to be less of a drag in 2025

• Active managers are maintaining their banks underweight, even while the underweight expanded due to Q4 outperformance. They note that the earnings outlook for the banks, while stable, offers lower growth than other sectors. Managers also consider that the underweight to the sector is unlikely to hurt as much in 2025 as it did last year, due to P/E (price-to-earnings) multiples being at all-time highs and higher than their global peers.

Keeping up the energy

• Many value-biased managers are overweight energy, which was a drag on relative performance in calendar 2024. Managers consider these holdings a source of future outperformance, noting that the sector is trading at historically low forward P/E ratios.From a bottom-up perspective, managers believe that capital expenditure for large projects has weighed on the share price for some companies and expect it to become a tailwind as the projects near completion and become revenue earning. They also expect the positive attitude that the Trump administration has toward fossil-fuels will be favorable for Australian-listed energy companies.

Preference for U.S.-exposed businesses

• Managers are preferring stocks where a major part of the revenue is from U.S.-based consumers and companies. Due to the Reserve Bank of Australia not yet starting the interest-rate easing cycle, coupled with the high cost of living for Australian consumers, they are wary of businesses reliant on the Australian consumer. The U.S. is seen as a better exposure, with interest rate cuts having started and the Trump administration expected to be more business-friendly.

Listed vs. non-listed: New cycle brings new opportunities

• Private real estate valuations have moved back in line with historical values and liquidity. With returns improving, this provides a favorable backdrop as we enter a new real estate cycle.
• Increased volatility and a wider dispersion in asset and sector returns are expected moving forward, increasing the importance of finding high-quality assets.
• Aside from the office sector, occupancy levels are strong and growth is expected to be positive across sectors.
• Returns are expected to become more income-driven after benefitting from yield compression in the previous cycle.

Real estate: Fundamentals remain strong in tough environment

• The slowdown in rate cuts has dampened positive sentiment, but fundamentals remain strong, and market volatility presents compelling opportunities for active managers.
• Data centers continue to see strong demand, driven by AI and hyperscale projects, but remain constrained by power supply.
• Managers are bullish on senior housing, driven by an aging population and supply growth that’s near record lows.
• Slowing population growth in Canada, combined with potential tariffs could create a difficult environment for Canadian REITs (real estate investment trusts).

Infrastructure: Piping in the energy

• Managers expect that favorable regulatory shifts and increased U.S. production volumes are positioning the energy midstream sector for sustained growth.
• If the new U.S. administration accelerates energy infrastructure projects, it will be positive for the pipeline and LNG (liquified natural gas) storage names.However, state and local opposition may limit implementation.

Infrastructure: Wary of interest-rate-sensitive sectors

• Managers are tempering their exposure to interest-rate sensitive sectors, including cell towers and U.S. utilities, due to the risk of higher-for-longer interest rates