Research sector update: Navigating near-term volatility

Investors kicked off 2025 in a generally upbeat mood, encouraged by a resilient U.S. economy, moderating inflation, and the potential for interest rate cuts and pro-growth fiscal policies. But by the end of the first quarter, optimism gave way to increased uncertainty about tariffs and their potential impact on inflation and economic growth. Initially, this shift benefited sectors viewed as being traditionally defensive (Exhibit), but heading into Q2 even these perceived safe harbors have come under pressure.

As such, we think it is all the more important for investors to focus on fundamentals, seeking out firms with the ability to pass on price increases and with strong management teams and exposure to secular growth trends. Yes, tariff uncertainty is here for now, but we believe themes such as artificial intelligence (AI) and the electrification of the global economy will endure for years to come. And now, as uncertainty weighs on stocks broadly, investors might be able to gain exposure to these long-term growth drivers at attractive valuations.

Technology: AI’s potential remains tremendous, but path may not be smooth

Denny Fish and Jonathan Cofsky

What happened: Mega-cap U.S. tech companies lost ground in the first quarter following an impressive multiyear run. The pullback was partly due to a recalibration in expectations about how much companies will need to spend over the long term on AI – a recalibration ignited by Chinese start-up DeepSeek, which claimed it had developed a very capable AI model using a fraction of the investment required by competing models. Microsoft added to concerns by announcing reductions to its own planned AI spending.

Looking ahead: The second quarter opens with additional uncertainty around tariffs, a pullback in enterprise spending, and fears of a broader slowdown that could have negative implications for economically sensitive market segments, such as analog manufacturing and Internet platforms dependent on advertising revenues. While we recognize near-term uncertainty, we remain excited about the long-term growth opportunities in technology, both from cyclical growth industries, such as semiconductors, and secular growth businesses, including those tied to generative AI. We believe the long-term investment opportunities around AI remain on track, even as we recognize we could see periods of volatility, as happens with any new technology. But we believe any improvement to efficiency will help broaden AI adoption across the global economy while inevitable periods of volatility will help facilitate the effective allocation of capital.

Communication Services: Long-term opportunities around AI and digital disruption

Josh Cummings

What happened: Communication services stocks had mixed performance in the first quarter. Strong advances by companies such as Netflix and T-Mobile were offset by a retrenchment in stocks viewed as beneficiaries of AI-related spending. We also saw a sell-off in a few high-valuation stocks within the sector.

Looking ahead: Near term, we recognize economic uncertainty could have negative implications for advertising, data centers, and spending in the digital sphere. We also believe we could see periods of volatility as investors try to gauge the appropriate level of AI capital investment. We think investors can use this volatility to their advantage to seek out great business models that may trade at significantly lower valuations relative to the start of the year.

Longer term, we remain excited about opportunities around AI, which we believe has the potential to be more pervasive and powerful than what consensus expects today. We also see long-term opportunities in digital streaming and digital advertising, and we expect continued consolidation around the largest, digitally native platforms best equipped to attract both content and users.

Healthcare: Finding both innovation and defense at attractive valuations

Andy Acker

What happened: Healthcare stocks ended the quarter with positive returns, but performance within the sector was mixed. On the one hand, healthcare service firms and large-cap biopharma outperformed, benefiting from low valuations and a market rotation into defensive assets. In contrast, small- and mid-cap biotech firms came under significant pressure amid policy uncertainty following Robert F. Kennedy, Jr.’s confirmation to lead the Department of Health and Human Services and funding and staffing cuts at federal health agencies, including the Food and Drug Administration.

Looking ahead: We think investors will continue to favor healthcare companies that tend to benefit from steady demand regardless of the macro backdrop. That includes drug distributors, which could also be more insulated from tariffs. In biotech, small- and mid-cap companies remain an important source of innovation, originating most new drugs, including 85% in 2024. The stocks also now trade at deep discounts. But given near-term policy uncertainty and the potential for regulatory delays, we think investors should favor smaller biotechs with recently approved products or promising late-stage pipelines.

Industrials: Staying disciplined in an increasingly uncertain capex environment

David Chung

What happened: Industrial stocks faced crosscurrents in the first quarter, resulting in muted performance. Orders and other leading economic data were generally positive. However, we saw a sharp shift in sentiment by quarter-end due to large government spending cuts and the threat of a trade war that has upended corporate decision-making and supply chains. It also appears that at least part of the strength we saw in the first quarter reflected pre-buying ahead of tariffs, rather than a real manufacturing recovery.

Looking ahead: As the second quarter begins, we recognize that new developments on tariffs could lead to higher inflation across the industrials sector while raising the odds of both industrial and consumer recessions. As such, we think investors should remain focused on companies aligned to strong secular trends, such as commercial aerospace and electrification, which may be less impacted by cyclical pressures. We also think it is important to seek out strong management teams equipped to manage policy uncertainty and to remain alert to companies working to improve their business execution and financial performance, even in a choppy environment.

Financials: Cyclical and secular trends offer compelling growth opportunities

John Jordan

What happened: The first quarter saw increased volatility as higher tariffs and the potential for a trade war fomented increased uncertainty around the economic and interest rate outlook. It also created a difficult environment for corporate decision making, leading to a slowdown in mergers and acquisitions.

Looking ahead: Despite near-term uncertainty, we believe the global financial services sector remains a rich landscape in which to deploy deep fundamental research. Favorable cyclical trends exist across many areas of the global financials market, especially around pricing in U.S. personal automotive insurance and in some areas of commercial property and casualty insurance. We are also excited about secular trends, such as growth in electronic payments and businesses leveraging proprietary data and advanced technological capabilities. Finally, we think several European banks are positioned to benefit from significant capital return, an improved regulatory backdrop, and the potential for industry consolidation.

Consumer: Staying focused on high-quality opportunities amid waning consumer confidence

Josh Cummings

What happened: Last quarter we warned, “the scope for surprise remains unusually wide given the recent elections and punchy valuations.” This certainly proved the case in the first quarter, as optimism around a strong economy gave way to growing concerns over the job market, declining consumer confidence, and the potential for higher inflation as tariffs take effect. Although economic data reported during the quarter were generally favorable, investors began to brace for bad news to come, leading to a rotation away from consumer discretionary stocks to more defensive consumer staples names.

Looking ahead: It remains to be seen whether negative consumer expectations become reality but shifting trade policies have become a source of uncertainty for consumers and investors alike. Against this backdrop, we believe investors should favor a mix of cyclical and defensive businesses to mitigate implied macroeconomic bets and stay focused on high-quality, resilient business models. We also think investors should seek out companies on the right side of digital disruption — a theme that has permeated the consumer sector for more than 20 years and shows no signs of abating.

Energy & Utilities: Downside risk to oil prices calls for defensive positioning

Noah Barrett

What happened: Energy outperformed the broader market in the first quarter, driven by solid fundamentals and a capital rotation from other sectors. The price of oil, while volatile, averaged $75 per barrel, a level that supported solid returns for most companies. While performance was broad-based, investors favored larger, more defensive names with economies of scale and resilient dividends.

Looking ahead: Demand fundamentals appear healthy but may weaken with increased recession risk. From a supply standpoint, domestic producers generally adjust quickly to any material change in prices. Globally, OPEC+ supply decisions may be complicated by geopolitical factors such as sanctions. Some Trump policies may put upward pressure on oil prices, but the White House appears committed to lowering oil prices even if it means incentivizing incremental supply or through policies to reduce demand. Overall, we see greater downside risk to oil prices, both because of the potential for weaker demand or higher-than-forecasted supply.

As such, we think investors should remain defensive in their positioning while staying alert to dynamics in the broader energy market. In our view,  integrated oil, midstream, and large, diversified exploration and production companies offer the most attractive balance of risk/reward.

IMPORTANT INFORMATION

Consumer discretionary industries can be significantly affected by the performance of the overall economy, interest rates, competition, consumer confidence and spending, and changes in demographics and consumer tastes.

Consumer staples industries can be significantly affected by demographics and product trends, competitive pricing, food fads, marketing campaigns, environmental factors, and government regulation, the performance of the overall economy, interest rates, and consumer confidence.

Energy industries can be significantly affected by fluctuations in energy prices and supply and demand of fuels, conservation, the success of exploration projects, and tax and other government regulations.

Financials industries can be significantly affected by extensive government regulation, subject to relatively rapid change due to increasingly blurred distinctions between service segments, and significantly affected by availability and cost of capital funds, changes in interest rates, the rate of corporate and consumer debt defaults, and price competition.

Health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.

Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.