Buy These Stocks If The FED Pivots... NOT the S&P 500Investing in the S&P 500 index is not always the best way to profit from an anticipated Federal Reserve pivot towards lower interest rates. While U.S. equities may rally when the Fed reduces the pace of its rate hikes, international equities are likely to be an even better performer for dollar-based investors. This is because the U.S. dollar's strength against other currencies is likely to weaken after a Fed pivot, and if this happens, an investment in non-U.S. stocks will earn a double return from the stocks themselves and from the appreciation of those stocks' local currencies. The double-return potential of international equities has been illustrated in recent months, with the U.S. dollar index falling 8.3% between September 28 and December 5, and the MSCI's ACWI-ex-U.S. index beating the S&P 500 by 6.4 percentage points.
The potential outperformance of international equities over the S&P 500 in the event of a Federal Reserve pivot towards lower interest rates can be attributed to the likely weakening of the U.S. dollar's strength against other currencies. This is because, as the Fed eases, it could weaken the dollar, which would be favorable for non-U.S. markets and dollar-based investors.
The past few months provide a good example of the double-return potential of international equities. Since reaching its high on September 28, the U.S. dollar index has fallen by 8.3% through December 5. During this same period, the MSCI's ACWI-ex-U.S. index, which reflects the return of an index of non-U.S. stocks, has outperformed the S&P 500 by 6.4 percentage points, with a return of 14.2% compared to 7.8% for the S&P 500.
It is worth noting that the fate of the dollar on foreign exchange markets depends on factors beyond the timing of the Fed's pivot. It also depends on the actions of the central banks of the United States' major trading partners. However, it is likely that the Fed will pivot before these other central banks, as they were slower to recognize the persistence of inflation. For example, European central banks were even slower to recognize inflation than the Fed, and as a result, eurozone inflation is currently higher than U.S. inflation.
In light of these factors, investors may want to consider shifting their equity portfolio's asset allocation away from U.S. stocks and towards non-U.S. stocks if they are confident that the dollar has further to decline. Even if investors are merely agnostic about the fate of the dollar, they may want to split their equity portfolio evenly between U.S. and non-U.S. stocks. The only scenario in which investors may want to concentrate their portfolio in U.S.-based companies is if they believe that the dollar's foreign exchange value will continue to rise even more than it already has in recent years.
