Which sector will lead the market in 2025?

Good morning. Nissan and Honda are holding merger talks. From an industry and investor point of view, this makes sense. The global car industry is capitally intensive, highly competitive and buffeted by change. Still, cars all look pretty much the same already; a few more mergers, and they will all be the same. Email us about the best car you’ve ever owned: [email protected] and [email protected].

Prediction time! (part 1)

The new year is approaching, which means that it’s prediction season. In markets, the great majority of predictions are too vague to be interesting, or correct only by chance, or wrong. This makes sense: at its core, the market is already a well-designed prediction machine for corporate performance and economic fundamentals. Seeing that the market has placed the wrong probability on a significant future trend or event is very hard — the domain of brilliant people operating at the peak of their powers in a fleeting window of market inefficiency.

Should us normals even bother with market predictions, then? Yes, for three reasons. Taking the risk of making a public prediction forces you to test your own assumptions; it is a way of finding out what you really believe. Predictions force you to look closely; they are a way to think about what is already priced in. Finally, and probably most importantly, making a prediction and turning out to be wrong is a great way, possibly the best way, to learn.

Unhedged is celebrating prediction season with a look at stock market sectors. Here is a quilt diagram showing the total return ranking of the 11 S&P 500 sectors over the past two decades (match the colour of the performance figures to the sectors at left; for example, communications, in grey, is the leader so far this year with 45 per cent, followed by info tech in pink and consumer discretionary in purple):

Rather than going though the sectors one by one, let’s consider some themes that will be important in 2025, and what they might imply for sectors:

Market narrowness/megacap dominance: the sectors that won in 2024 won because of a few very big stocks that rose a lot. The communication services sector, for example, was the overall leader only because three huge names — Alphabet, Meta and Netflix — now make up almost 80 per cent of the sector market cap, and they all had stellar years. If, as just about every Wall Street strategist predicts, market leadership is going to broaden in 2025, the sector deck is going to be reshuffled.

AI hype: If the AI-will-change-everything narrative loses some shine in ‘25, staying away from the information technology sector is the obvious play: Microsoft, Nvidia and Broadcom make up almost half of the sector weight. A less obvious victim of diminishing AI lustre would be utilities, which have gained 25 per cent this year in large part because of anticipated data centre power demand. 

US & global economic growth: If you think the post-pandemic expansion has legs, stick with the classic cyclicals: financials and industrials. A more contrarian bet would be that global growth, and especially Chinese growth, surprises to the upside, which would help the materials and energy sectors, both of which underperformed massively in 2024.

Inflation and rates: The market is pricing in inflation that stays tame, and three Fed rate cuts. What if inflation picks up again and short rates stay high, instead? It depends on the reason: if the inflation results from an overheating economy, energy and financials could do well. If we get stagflation, devil take the hindmost, but staples and healthcare will probably be the foremost, à la 2022, while real estate will get hit both coming (demand) and going (rates).

Trump administration policy: If you think Donald Trump can deliver on his promise to cut energy prices by half, you know what to do: sell energy and utilities. Healthcare stocks are already trembling before Trump’s promise to “knock out the drug middlemen”. Those are the pharmacy benefit managers, which are owned by the big insurers. The efforts of Elon Musk and DOGE to cut federal spending may come out of insurers’ and drugmakers’ hides, too.

But Trump’s promise of deregulation should help finance. Of course, having the CEO and founder of Tesla (which accounts for a fifth of the consumer discretionary sector) in the White House should be good for that company. But surely, after a 90 per cent run since the election, all that is priced in and more?

So what kind of year does Unhedged predict, and which sectors will lead? We will lay out our thoughts tomorrow. Send us your thoughts today, so we can steal them.

Brazil

The Brazilian real hit an all-time low on Tuesday, prompting intervention by its central bank. The culprit: a lack of market confidence in Brazil’s fiscal policy.

Brazil’s deficit has ticked up as a percentage of GDP since President Luiz Inácio Lula da Silva re-entered office in early 2023. Investors have balked at his party’s most recent budget proposal, which will reduce the country’s growing annual deficit, but not by much, and will not address rising interest payments. Here is a graph of the deficit as a percentage of GDP, which breaks out net interest payments and annual deficits, courtesy of Robin Brooks at the Brookings Institution:

Bond yields have been steadily rising over the year, up to the highs seen in the 2014-2017 economic crisis. Brazilian stocks have come down, but on a much choppier path.

But what really caught our eye is the cratering real. This is a reflection of the fact that a large portion of Brazil’s debt is in real, and held by local investors. Given that, the government may be tempted to solve their budget problems by meddling with the currency, rather than closing the deficit. Thierry Wizman, global FX and rates strategist at Macquarie Group, explains:

The idea is that if a country cannot pay its local currency debt through more borrowing, the central bank will have to come to the rescue, by printing money, which will debase the currency. Or the government will force the central bank to keep rates low, in order to more easily service the debt. So [for the market] it all comes back to the currency . . . 

The policy rate is currently 12.3 per cent, and inflation is still hovering at 5 per cent. But Lula’s recent remarks, and his unwillingness to budge on the deficit, have given investors reason to believe he might try to undermine central bank independence to shrink the deficit. So they are selling the currency.

Emerging market currency crises play out differently when most of the debt is in dollars — as investors saw in the 1980s. When a distressed country has to service its debt in dollars, the government must swap its currency for dollars, use the central bank’s dollar reserves, or get an IMF package. In many cases, the market would front-run the government and sell off the EM currency, but in response to higher borrowing costs or reserve depletion — not to anticipate reckless monetary policy.

In recent years, more developing countries have been issuing local currency debt. There has been a lot of excitement about the switch, which reduces exposure to US rate policy, supporting EM fiscal stability. But local debt only reduces risk up to a point. If investors don’t like the direction of fiscal policy, and central bank independence is not assured, currencies will still crash.

(Reiter)

One good read

Holy humour.

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