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Written by: Kent Hargis, PhD
Equity markets are facing three major sources of volatility in 2025. Uncertainty over the incoming US administration’s policies, along with challenges driven by artificial intelligence (AI) and shifting macroeconomic conditions, could all prompt market turbulence.
But risk-averse investors shouldn’t give up on equities. Carefully curated defensive strategies can help investors position for potential instability, while capturing return potential in companies that can overcome the hurdles ahead.
Trump 2.0: What’s Different This Time?
Some investors might draw comfort from President Donald Trump's first term in office. After all, stocks performed well from 2016 through 2020, and market volatility was relatively benign.
We think that’s an oversimplification. As Trump’s new term begins, market conditions are very different than when he first took office in 2016. At the end of 2024, the US equity market price/forward earnings ratio reached 21.1×—about 29% more expensive than in late 2016 (Display).
Meanwhile, growth stocks are much more expensive versus the broad market than they were in 2016. At the same time, defensive stocks—represented by the MSCI USA Minimum Volatility Index—are trading at relatively inexpensive valuations versus the broad market.
Macroeconomic conditions have also changed, with the US facing higher inflation than in 2016 and a fiscal deficit that has widened dramatically to 6.7%.
In our view, current market and macro conditions warrant caution from investors and set the stage for potential bouts of market volatility, especially given the risks on the horizon.
Risk 1: Trump’s Policy Agenda Spells Uncertainty
Trump’s pro-business credentials mask many policy uncertainties. In his initial executive orders, Trump moved to deregulate the energy industry, and he has reiterated promises to cut corporate taxes. Then, in February, he decided to impose tariffs on China, Canada and Mexico. Measures like these seek to sharpen the competitive edge of US businesses.
But policy details will take time to formulate, and their effects on US and global companies won’t be clear overnight. Tariffs, for example, aim to make imports to the US less competitive. In reality, the effect of tariffs will differ across sectors, industries and companies.
For example, goods manufacturers have more of their revenue exposed to potential tariffs than services companies, according to our analysis of MSCI World constituents. In the technology sector, semiconductors and hardware companies are much more vulnerable to tariffs than software firms.
As markets struggle to digest the impact of tariffs on individual companies, we expect volatility to increase. This could create opportunities in companies that are mistakenly branded as victims of tariffs (Display). Select companies that have moved to optimize supply chains in recent years could surmount tariff risk and deliver positive surprises in earnings and returns.
Other policy changes, from deregulation to tax cuts, could create opportunities for investors. We believe that the effects of these policy changes will filter down to sectors, industries and companies in uneven ways, creating market volatility along the way.
Risk 2: The Precarious Path of AI
AI has arguably been the most powerful business theme for equity markets over the last two years. The promise of a revolutionary technology that might fuel productivity has captured the imagination of investors and propelled the so-called Magnificent Seven—the US mega-cap stocks—to record gains and market dominance.
But the road from disruptive technology to sustainable growth is fraught with risks. Yes, the Mag Seven include quality businesses that may benefit from looser regulation under Trump. But high valuations raise questions about their ability to deliver on long-term earnings growth expectations. As we see it, passive US and global portfolios that are highly concentrated in the mega-caps look vulnerable to a change in sentiment, which could also stoke market volatility. Indeed, technology stocks tumbled on January 27, wiping out more than $1 trillion of market value, as Chinese company DeepSeek’s rapid AI advances raised questions about future spending.
The good news? There are ways for investors to gain exposure to AI while maintaining a defensive mindset.
Semiconductor companies are relatively expensive based on their price/free-cash-flow yield. But software and hardware stocks trade at more reasonable valuations (Display), and in these industries, investors can find quality businesses that are AI beneficiaries and enablers. This strategy can provide a defensive equity portfolio strategy with access to the AI story while mitigating some of the risk that comes with holding large weights in the heavyweight names.
Risk 3: Diverging Dynamics in the Global Economy
Macroeconomic risk always influences equity markets. But this year, we think the dramatic US policy changes amid diverging global economic conditions could trigger acute market volatility.
Some of Trump’s policies are seen as good for growth, but they also add to concerns about fiscal sustainability and are likely to be inflationary, which could lead the US Federal Reserve to slow the pace of interest-rate cuts. Given the policy uncertainties, the range of potential outcomes is wide, with AB economists projecting only a 20% probability of a recession this year.
We might also see more economic divergence globally. Trump’s tariffs could weigh on China and Europe, regions already coping with lackluster economic growth. Chinese stimulus is a wild card. In Europe, where inflation is heading toward target, the European Central Bank should be able to continue cutting rates through the year.
To address these risks, we think defensive investors should aim to build macro-resistant equity portfolios. In our view, that requires using fundamental research to focus on quality businesses that aren’t tethered to macroeconomic outcomes.
Equities are still vital in today’s markets. Stocks have a good track record of delivering solid real returns—above the rate of inflation—over time. We believe that stocks backed by high-quality businesses, with stable trading prices and attractive valuations—what we call quality, stability and price—can form the backbone of an effective defensive strategy for today’s fluid market and macro conditions.
Allocating to equities that help cushion portfolios during downturns can help investors with lower risk appetites stay on track in a world of politically driven instability that could rattle markets in unpredictable ways.
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