Stocks rallied last week as investors looked past the tragic attacks in Paris and once again focused on central bank policy. In particular, investors celebrated the potential for more central bank divergence: tightening by the Federal Reserve (Fed) while the European Central Bank (ECB) pursues easing.
In the U.S., investors now appear to be treating a December Fed rate hike as a sign of economic stability rather than something to be feared. As such, investors were cheered last week by the October Fed meeting minutes, which implied that the central bank views the economy as strong enough to justify an initial rate hike, most likely in December.
Meanwhile, European stocks continued to rally on hopes for more monetary stimulus, rather than signs of economic recovery. Investors got what they were looking for last week, with several ECB officials confirming the likelihood that the central bank will expand its quantitative easing (QE) program.
As I write in my latest weekly commentary “Cheering, Not Fearing, a Rate Hike?” as these central banks diverge, there are several implications for investor positioning.
Consider overweighting hedged European equities. A falling euro and an ECB likely to expand its monetary stimulus are both catalysts for European stocks. The one caveat: Given that further gains are partly predicated on a weaker currency, dollar-based investors should continue to consider currency-hedged vehicles.
In the U.S., consider adopting a modest tilt toward large- and mega-cap stocks. At first blush, my preference for U.S. large-cap stocks seems counterintuitive given expectations for a stronger dollar. Generally, a strong dollar is seen as more of a headwind for large caps, which have a greater exposure to international sales.
However, this year has demonstrated how the relationship is more complex. Yes, a stronger dollar has proved a headwind for large-cap company earnings, but small caps have actually been underperforming, according to Bloomberg data. Part of the reason has to do with why the dollar is appreciating: rising real (after-inflation) interest rates. As data accessible via Bloomberg show, U.S. real 10-year rates are up roughly 60 basis points (0.6 percent) since the end of January.
This, in turn, is having an impact on small-cap valuations, based on Bloomberg data. Through October, S&P 500 Index multiples actually rose a bit. However, the price-to-earnings ratio on the Russell 2000 Index of small-cap stocks contracted by around 2.5 percent. It should be noted that this is consistent with history.
Looking forward, to the extent we see a gradual rise in real rates, higher real rates are likely to keep small-cap valuations under pressure. Finally, according to Bloomberg data, large- and mega-cap names also have the advantage of cheaper valuations relative to the broader market.