TD Waterhouse Canada Inc. says that U.S. politics is likely to have a “muted” effect on markets this year, while investors should see large cap stocks outperform small caps.

Those are just some of the findings of the firm’s 2005 Investment Outlook, which was released today.

TD Waterhouse says the market should avoid the negative returns characteristic of the first year of a new presidency, when harsh fiscal medicine is generally doled out. Instead, earnings growth in the 5-6% range and equity valuations that are not excessive should result in modest equity gains.

The firm’s advice for investors is to remain overweighted in equity for the moment, while keeping a sharp eye out for risks such as rising short-term interest rates.

TD Waterhouse that U.S. small cap stocks have out-performed their large cap counterparts, but they will likely underperform them in 2005.

It says large caps are a good bet, and adds that Canadian insurers and diversified financials, such as Manulife, Sun Life Financial and Power Financial, should have solid years, though somewhat less buoyant than in 2004.

TD Waterhouse says investors should be underweight in bonds, as short-term interest rates are expected to move up modestly in 2005, with longer-term bond yields rising slightly less.

The brokerage firm says income trusts will likely become divided into high- and low-quality groups in 2005. It says the “marginal players will likely be dealt with harshly in the market”, while “higher quality trusts with stable and sustainable distributions should outperform the broad market indices.”

Finally, TD Waterhouse says investors should consider overweighting Asian stocks in their portfolios for 2005. Japanese stocks should again outperform U.S. equities, due to strong corporate earnings growth, reasonable valuations, and rising exports to China.

“2005 should offer investors who pursue these themes a year of steady, modest growth,” said Robert Gorman, vp, managed investment solutions and head of TD Waterhouse Canada’s Asset Allocation committee. “While there are risks in the current environment, investors will be able to mitigate them by keeping their eyes open and by maintaining some flexibility in their portfolios so that they can shift their weightings quickly if needed.”