Since April's Liberation Day, equity markets have recovered losses and appear to be on an upwards trajectory. But under the surface of the highs are a market and economy looking for direction.
A series of rolling recessions and rolling recoveries can obscure the bigger picture. These vacillations might have seemed high stakes at the time, but in reality, the global economy has been bouncing along aimlessly for much of the last three years. Markets are caught between two opposing narratives: a goldilocks scenario of higher growth and lower inflation or higher inflation and faltering growth. The type of broad economic expansion or contraction that characterized past cycles has simply not occurred. Parts of the equity market have been bouncing sideways too: the wide sideways trading range US small caps have occupied between 2021 – 2025 is reflective of this macro backdrop.
As recently as 2022, equity investors could get a pretty good sense of where the market was headed by looking at ISM surveys, given their function as leading indicators for business activity. Readings above 50 generally signal good news for economic growth, which historically indicated favourable conditions for equity markets; readings below 50 generally indicate the reverse. For the last three or four years, the average figure has hovered around 50 — not really in contraction, but also not really in expansion: a "hung economy," offering no clear direction to investors one way or the other.
Why is the economy so stuck?
The last five years have seen some dramatic changes to drivers of economic activity — such as the impact of lockdown on consumer behaviour, the trajectory of monetary and fiscal policies, the geopolitical climate, Trump, and the impact of AI. At the heart of this impasse is a recurring theme of bifurcation. I think there are five key factors driving this, many of which compound each other:
A wedge between goods and services
Global growth is really a services story, but what's noteworthy is that we've never seen such a pronounced bifurcation between the goods and services sides of the global economy. This harks back to the pandemic and its impact on our spending patterns. None of us were spending money on services during lockdowns, but demand for goods was strong. When society opened up, spending on services became a priority once again, especially given the impact of supply chain issues on goods.
The uneven impact of fiscal stimulus
A critical factor in the bifurcation between goods and services is the uneven impact of fiscal stimulus. Fiscal stimulus surged during the pandemic, benefiting some parts of the economy — such as services and large-scale tech investment (for example, CHIPS Acts in the US and EU) — more than others, leaving other parts of the economy behind.
Monetary policy — a good time to own assets, a bad time to have debt
Just as fiscal policy benefits some and not others, higher rates also create a set of winners and losers. Large corporations and wealthier consumers — those that tend to have assets — have been huge beneficiaries of higher rates, through higher interest income and asset price inflation. Small businesses, governments, and poorer consumers — those that tend to have debt — have been hit hard.
Regulation hasn't levelled the playing field
Post-pandemic regulation — especially around health and safety, credit, energy, and labour — spiked in many economies around the world. While well-intentioned, increased regulation has had marginally less impact on the wealthy and the powerful and more impact on the less wealthy and less powerful, again contributing to a dynamic where the rich get richer and the poor get poorer.
AI — the incumbents have it?
While the end game is unknown, there is no question that to date the winners of the last technology revolution (internet and mobile) are perceived as the winners of the next tech revolution — AI.
What does this mean for equities?
For equity markets, these dynamics translate to a sustained set of winners and losers even as the overall direction of the economy remains uncertain.
In this environment, investors are concerned about the ability of active equity managers to generate alpha. Broadly speaking, alpha opportunity is a function of three key factors: breadth, dispersion, and correlation. As narrow markets have become even narrower, breadth has been a huge headwind in recent years. However, interestingly, I see signs that increased dispersion and reduced correlation have started to improve alpha opportunities. Meanwhile, there are also indications that economic growth is beginning to widen, leading to some broadening in EPS growth. Two out of the three factors that support alpha opportunity are moving in the right direction — and there is some early evidence that breadth is starting to improve too.
Where to look for opportunities now
When active management comes back, it may benefit from multiple tailwinds. In the meantime, if market concentration persists, asset owners may wish to expand their opportunity set by considering the following: exploring strategies that can help add alpha from greater dispersion in concentrated markets, increasing the breadth of the opportunity set, and targeting less efficient markets, such as Europe, emerging markets (EM) and small caps.
Europe
Europe is in the midst of structural regime change but portfolio positioning is key. Sectors that are geared toward domestic demand, such as telecoms, banks, and construction, along with defense stocks and utilities — which tend to be more value and small-cap oriented — appear to be the likeliest winners of Europe's transformation.
EM
EM equities are currently experiencing record levels of dispersion across countries, both in performance and valuations. A sustained weakness in USD is also particularly beneficial for EM equities. Finally, it's worth remembering that many EM economies still maintain very high real policy rates, so further cuts in US interest rates should provide more scope for lower rates and accommodative monetary policy across EM markets, potentially boosting equity performance.
Small caps
No segment of the market likes lower rates more than small caps. We've seen the first positive revisions for small caps for three years and a pronounced rally in lower-quality small caps. US small caps should also benefit from OBBA tax benefits that start to roll through in late 2025 and into 2026.
While market concentration poses risk for active investors today, it may also be planting seeds of opportunity for tomorrow. Historically, periods of concentration tend to have a finite lifespan. When they do, "concentrated" exposures often suffer sharp underperformance, both on a relative and even an absolute basis. By broadening the opportunity set, investors can position themselves to capture alpha as it returns.
