The S&P/ASX 200 Index (ASX: XJO) is projected to face increased competition from two sectors expected to outperform in 2026: defence and small caps. The ASX 200 has recorded a rise of approximately 9.7% over the past year, aligning closely with its long-term average annual return of 9.3%. As market dynamics fluctuate, investors are encouraged to focus on sectors that may benefit from significant underlying trends.
Defence Sector Gains Momentum
Global defence spending is on the rise, driven not only by ongoing conflicts and geopolitical tensions but also by a push to modernize military technology. Nations are investing heavily in upgrading ageing fleets of aircraft, vehicles, and equipment. Recently, NATO members committed to increasing collective defence spending to 5% of GDP by 2035, a notable increase from the previous benchmark of 2% established in 2014.
In Australia, the government has unveiled an additional investment of $50.3 billion in the Australian Defence Force as part of its long-term strategy. This investment underscores the country’s commitment to enhancing its military capabilities. Moreover, Japan’s incoming Prime Minister, Sanae Takaichi, has expedited the nation’s aim to reach 2% of GDP in defence spending, moving the target date up to 2026.
As these nations ramp up their defence budgets, companies that supply advanced defence systems—ranging from drones to AI-enhanced surveillance—are likely to benefit significantly. Notable ASX-listed companies like DroneShield Ltd (ASX: DRO) and Electro Optic Systems Holdings Ltd (ASX: EOS) have already seen their share prices surge, reflecting growing orders and investor confidence stemming from increased defence spending.
Investors interested in diversifying their exposure within this sector may consider exchange-traded funds (ETFs) such as the VanEck Global Defence ETF (ASX: DFND) and the Betashares Global Defence ETF (ASX: ARMR). These funds provide access to major international defence firms like Lockheed Martin and BAE Systems, which are at the forefront of developing next-generation defence technologies.
While the trend in defence spending appears strong, potential valuation risks exist following recent rallies. A diversified investment strategy may offer a prudent approach to participating in this ongoing re-arming cycle.
Small Caps on the Rise
On the other end of the market spectrum, smaller companies are also positioned for potential growth in 2026. The S&P/ASX Small Ordinaries Index (ASX: XSO) has experienced a remarkable increase of nearly 22% this year, significantly outperforming the ASX 200’s 9.7% gain. This rebound marks a sharp turnaround after several years of underperformance.
The resurgence of smaller companies can be attributed to their agility in responding to improving market conditions. With the Reserve Bank of Australia expected to ease interest rates in 2026, lower borrowing costs could serve as a substantial tailwind for these businesses. Additionally, many small caps are currently trading at more attractive valuations compared to larger, fully-priced blue-chip stocks.
For investors seeking a diversified approach within the small-cap sector, the VanEck MSCI International Small Companies Quality ETF (ASX: QSML) focuses on a selection of 150 of the world’s most reputable small businesses. These companies are evaluated based on their returns on equity, stable earnings, and low financial leverage—criteria historically associated with strong long-term performance.
Identifying significant trends, such as the modernisation of defence capabilities and the recovery potential of small-cap firms, can assist investors in building a well-rounded portfolio. While no strategy guarantees market outperformance, sectors showing robust growth prospects present intriguing opportunities for those willing to look beyond standard benchmarks.
