While the S&P/ASX 200 Index (ASX: XJO) quietly clocks another year of near-average returns, a few sectors are starting to sprint ahead of the pack.
The ASX 200 is up around 9.7% over the past 12 months. That's almost perfectly in line with the long-term average annual return of roughly 9.3%.
Of course, markets never move in straight lines. Some years surge ahead, others pull back, and over time, it all averages out. So rather than trying to predict where the ASX 200 will end up next year, I prefer to look for areas of the market where powerful tailwinds could create a little extra lift.
Two sectors currently stand out: defence and small caps.
Image source: Getty Images
The global re-arming cycle
Defence spending is rising across the world, and not just because of ongoing conflicts or geopolitical tensions. Nations are also modernising their military technology, replacing ageing fleets of aircraft, vehicles, and equipment in what is effectively a decades-long upgrade cycle.
NATO members recently agreed to increase collective defence spending to 5% of GDP by 2035, a significant step up from the long-standing 2% benchmark set in 2014.
Closer to home, Australia unveiled an additional $50.3 billion investment in the Australian Defence Force earlier this year as part of its new long-term strategy.
And in Asia, Japan's incoming Prime Minister Sanae Takaichi has fast-tracked the nation's goal of reaching 2% of GDP in defence spending, bringing the target forward by two years to 2026.
This means trillions of dollars will continue flowing to companies that design and supply advanced defence systems — from drones and radar to AI-enhanced surveillance and electronic countermeasures — over the coming decade.
On the ASX, DroneShield Ltd (ASX: DRO) and Electro Optic Systems Holdings Ltd (ASX: EOS) have already demonstrated the sector's potential. Their share prices have jumped as swelling global defence budgets translate directly into rising orders, stronger revenues, and renewed investor confidence.
However, defence is not just a local story. Investors seeking diversified exposure might consider ETFs such as the VanEck Global Defence ETF (ASX: DFND) or the Betashares Global Defence ETF (ASX: ARMR). These provide access to global giants like Lockheed Martin, BAE Systems, and RTX Corp — companies building the next generation of defence hardware and software.
The long-term trend looks powerful. Even so, valuation risks are worth keeping in mind after such sharp rallies. A diversified approach could be a safer way to participate in the global re-arming cycle.
Growth and recovery potential
At the opposite end of the market, smaller companies could also shine in 2026.
The S&P/ASX Small Ordinaries Index (ASX: XSO) has surged nearly 22% this year, outpacing the ASX 200's 9.7% gain. That's a sharp turnaround after years of underperformance.
Why the rebound?
Smaller businesses tend to respond faster to improving conditions, and with the Reserve Bank expected to ease rates in 2026, lower borrowing costs could provide a strong tailwind. Many small caps are also trading at more attractive valuations compared to large, fully-priced blue chips.
For investors who prefer a diversified approach, the VanEck MSCI International Small Companies Quality ETF (ASX: QSML) focuses on 150 of the world's highest-quality small businesses. These companies are screened for high returns on equity, stable earnings, and low financial leverage, the kind of financial discipline that has historically led to long-term positive performance.
Foolish Takeaway
There's no guaranteed way to beat the market. Even the most talented investors experience stretches where they don't outperform the ASX 200's average return.
Still, identifying structural trends — like defence modernisation or small-cap recovery — can help investors build a satellite portfolio around a diversified core.
Whether through individual shares or ETFs, these two areas offer fascinating potential for those willing to think a little beyond the benchmark. Just remember: outperformance is possible — it's just never easy.
