Sector Opportunities for Q2 2025

Investors who headed into 2025 focused on US exceptionalism were disappointed by Q1. US equities were down 4.3% and lagged their developed peers by more than 10%.¹ In fact, the S&P 500 was down 10% intra-quarter due to weaker US economic data and consumer sentiment amid a flurry of executive orders, DOGE actions, tariff uncertainty, and elevated equity valuations.

But these losses were concentrated in just two sectors — Consumer Discretionary and Tech. Seven sectors registered positive returns in Q1, highlighting good market breadth and abundant alpha opportunities for sector investing.

The run-up in US equities since 2022, led by a few mega-cap Tech stocks, has exposed portfolios to significant concentration risk. And as the Trump administration continues to dramatically reshape domestic policies and the world economic order, diversification is more important than ever.

To enhance equity portfolio diversification, investors can consider Software for more attractively valued secular growth exposure, Global Infrastructure to manage upside inflation and downside growth risks, and Regional Banks as a domestic-focused cyclical value exposure with strong earnings fundamentals.

Software: Position for the Next Phase of AI Monetization

Software stocks were under pressure in Q1, down more than 10% and 22% below their December peak, as investors sold high-flying tech stocks in a risk-off environment.² Market volatility may remain elevated amid economic uncertainty and Chinese Tech companies continuing to challenge US Tech’s dominance in the global AI race.

But the US software industry’s discounted valuations and its advantageous position in monetizing AI technology may provide investors an attractive opportunity to capture AI’s significant value creation.

DeepSeek’s lower-cost and open-sourced AI models likely will accelerate product innovation in the software industry and broaden AI application adoption. In fact, prices in AI models of equivalent performance are estimated to decline by 10x every year.³ By significantly improving hardware utilization and reducing computational requirements, Deepseek’s novel techniques bring down input costs for software companies to develop AI applications. This has advanced the timeline for increased use of AI by businesses and consumers and AI application proliferation. We may see improving return on investment for established AI application providers and burgeoning new opportunities for small players in the next few years.

Although AI infrastructure players from computer hardware manufacturers to hyperscalers and data centers have so far reaped the greatest benefits from AI investment since the release of ChatGPT, we’ve now come to the point where software companies have started monetizing AI by offering more economically viable AI solutions with strong capabilities.

Salesforce’s Agentforce platform is an example of how software vendors leverage agentic AI — a type of AI that can learn, adapt, and take actions on its own — to create new revenue drivers and improve efficiency for clients and themselves.

The Agentforce platform allows Salesforce customers to build and deploy autonomous AI agents that are specialized in executing tasks in specific areas like customer service, sales assistance, and marketing. Garnering more than 3,000 paid customers within just 90 days of its launch, the platform is driving the cross-selling of Salesforce’s core and Data Cloud products. Used to enhance Salesforce’s own efficiency, Agentforce has handled more than 380,000 conversations on the Salesforce website with an 84% resolution rate.⁴

Corporate IT leaders have already shown a strong appetite for AI-enabled solutions. It’s projected that worldwide spending on technology to support AI strategies will more than double to $749 billion by 2028, with more than two-thirds of the spending coming from AI-enabled applications and platforms.⁵ And the desired timeline on adoption of AI-powered software applications has become shorter.⁶

Despite a clearer path to AI monetization for software companies, industry valuations haven’t reflected broadening AI opportunities beyond a few cloud platforms that invest billions in AI infrastructure. The equal-weighted all-cap Software & Services industry exposure — the S&P Software & Services Select Industry Index — is trading near a record discount to its large-cap peers and the broad market (Figure 1).

To diversify from AI-related mega-cap Tech stocks while positioning for the proliferation and broader adoption of AI applications, investors may consider the SPDR® S&P® Software & Services ETF (XSW) which seeks to provide modified equal-weighted exposure to the Software & Services industry across the market cap spectrum.

Global Infrastructure: Manage Upside Inflation and Downside Growth Risks

Escalation in US trade tariffs has pushed economic uncertainty to its highest level since the pandemic,⁷ posing downside risks to growth and upside risks to inflation. Market-based and survey-based inflation expectations rose markedly in Q1, with the two-year breakeven rate and consumer one-year inflation outlook at their highest levels since 2022.⁸ Meanwhile, business and consumer surveys have shown weakening economic outlooks driven by tariff uncertainties. Even the Federal Reserve acknowledged the risk in the March FOMC meeting by moving its growth forecast lower and inflation forecast higher for this and next year.

Stocks of infrastructure-related businesses, like airports, railroads, utilities, and energy storage & transportation, may help investors enhance portfolio diversification and navigate economic uncertainties. They historically have exhibited resilience in slow growth and high inflation environments (Figure 2) thanks to their stable cash flows and strong pricing power. The resilient cash flows due to the essential nature of infrastructure assets may help companies maintain stable dividend payouts, which investors favor during an economic slowdown. A high barrier to entry and inflation-sensitive revenue streams allow infrastructure companies to pass inflation-related costs on to clients, providing an inflation hedge. And their outperformance over the broad market during the equity selloff in 2022 underscores their defensive nature in a weak growth and high inflation environment.

Demand for infrastructure assets has also been on the rise, driven by emerging secular trends like energy security, green transition, and digital transformation. The pandemic and energy shock following Russia’s invasion of Ukraine pushed European governments to introduce various funding vehicles and policies, such as NextGenerationEU (€807 billion), the Cohesion Policy (€392 billion),⁹ and Germany’s infrastructure fund (€500 billion)¹⁰ to modernize transportation, energy, and digital infrastructure. In China, the increasing adoption of renewable energy in residential and transportation sectors has resulted in higher demand for infrastructure for electricity transmission and distribution. And to keep up with the surging power demand from data centers, electric vehicles and manufacturing reshoring, the US needs to double the power grid’s capacity over the next 12 to 13 years.¹¹

Investors may consider the SPDR® S&P® Global Infrastructure ETF (GII) to capture strong demand growth in global infrastructure driven by multiple secular tailwinds, while seeking to manage upside inflation risks and prepare for a growth slowdown. Seeking to provide exposure to the 75 largest infrastructure-related stocks across developed and emerging markets, GII may help investors manage equity downside risks driven by growth and inflation uncertainties.

Regional Banks: Capture Fundamental Strength and Buyback Tailwinds at Attractive Valuations

We were bullish on regional bank stocks heading into Q1. Since then, an economic growth scare has cooled investors’ enthusiasm for Financials. In fact, Financials-focused ETF inflows are at their lowest level since October.¹² Regional bank stocks also have given back their post-earnings bounce and now sit below their beginning-year level and 14% below their post-election peak.¹³

Is the trough of bank stocks behind us or will there be more pain ahead? Despite a growing list of uncertainties, we remain positive on regional banks given their continued fundamental strength, buyback and de-regulation tailwinds, attractive valuations, and domestic-focused business.

Banks’ earnings fundamentals have improved since Q3 last year thanks to the expansion of net interest margin (NIM) and positive loan growth. The industry NIM expanded for the third consecutive quarter in Q4 driven by lower funding costs, while total loan balance grew at a faster pace than in 2023.¹⁴ Banks expected loan demand to strengthen across all loan categories in 2025 amid solid economic growth and lower interest rates, according to the latest Senior Loan Officer Opinion Survey.¹⁵ As a result, regional bank 2025 EPS estimates are near a one-year high, while the consensus growth estimate has been raised to 16.6% from 14.7% since the beginning of the year.

On the stock supply side, share buybacks by regional banks may continue to pick up in 2025, especially given the prospect of easing regulation to further support stock prices. The industry’s share repurchased value has almost doubled from a year ago in Q1, while the value of authorized repurchase programs reached $41 billion in total, increasing 34% from one year ago.¹⁶ The Trump administration’s deregulation agenda may ease bank supervision and relax capital requirements, paving the way for more share buybacks and the return of capital to shareholders.

Recessionary concerns have weighed on regional bank valuations back to last summer’s level — 16% below their long-term median (Figure 3). Relative valuations are even more attractive — around the bottom decile since 2011.¹⁷ Although a noticeable economic slowdown in the US is warranted after two years of near 3% real GDP growth, a recession is not our base case.

Potential tariffs may cause more pain for sectors intertwined in global supply chains or with significant foreign revenue exposures. Regional banks’ domestic-focused business may insulate the industry from direct impacts of trade conflicts. Current valuations of regional banks are underpricing the industry’s strong earnings outlook.

The recent price decline in the regional bank industry has created an attractive entry point for investors to position for the positive industry outlook and potential multiple expansion in a more industry-friendly regulatory environment. Consider the SPDR® S&P® Regional Banking ETF (KRE) to pursue the industry’s strong growth potential amid trade uncertainty.

To learn more about emerging sector investment opportunities, visit our sectors webpage.