Why investors should look beyond U.S. megacap stocks as interest-rate concerns ease

“While we believe investors should keep a core allocation to U.S. large-cap stocks in their portfolios, we also think exposure to other developed markets, emerging markets, and small-caps helps ensure investors don’t miss out on potential future growth drivers,” said a team of strategists led by Solita Marcelli, chief investment officer for the Americas at UBS Global Wealth Management, in a note shared with MarketWatch on Monday.

U.S. stocks hovered around their record-high territory over the past two months as the milestones for major benchmark indexes kept rolling in.

The S&P 500
SPX
on Friday notched its 13th record finish of 2024, while the Dow Jones Industrial Average
DJIA
posted its 14th record closing high over the same period, according to Dow Jones Market Data. The Nasdaq Composite
COMP
also briefly flirted with its record close last week, but remained just shy of that level as investors parsed the seemingly relentless stock rally driven by the blockbuster quarterly earnings from Nvidia Corp.
NVDA,
+1.70%.

However, the performance of international stocks and smaller U.S. companies is less impressive. The MSCI All Country World ex-US index
ACWX,
which captures large-, mid- and small-cap stocks across 22 of 23 developed markets that excludes the United States, has gained 1.6% year-to-date, compared with a 6.6% advance for the S&P 500 over the same period, according to FactSet data. The small-cap Russell 2000
RUT
index is flat for the year, lagging behind their large-cap counterparts after a sluggish 2023. 

See: Small-cap stocks haven’t been this volatile in nearly a year. What it means for the long-suffering segment.

But the U.S. market hasn’t always outperformed as market leadership has rotated over time historically, Marcelli and her team said.

For example, while the S&P 500 has outperformed global stocks substantially since 2007, it returned just 38% between 1999 and 2007. That compared with a 97% advance for the MSCI EAFE index
EFA
and 420% for the MSCI Emerging Markets index
EEM
over the same period, according to data compiled by UBS Global Wealth.

That’s why “a shift in regime” can not be ruled out in the future, and in case of such a rotation, international stocks that have lagged in recent years could benefit, said Marcelli and her team. 

See: Gauge of global stock-market performance logs first record close in 2 years

Meanwhile, potential interest-rate cuts by major central banks around the world and expectations that the U.S. economy could proceed toward a soft landing in 2024 also provide tailwinds to global stocks and small-cap equities, said UBS strategists. 

Since 1989, emerging-market stocks have delivered an average of 10% and 20% total returns in the six and 12 months, respectively, following the first interest-rate cut by the Federal Reserve, wrote Marcelli and her team. Additionally, smaller companies’ higher use of floating rates in their debt means they should feel the easing of financial conditions faster than their larger peers, the strategists said. 

What’s more, equity valuations in the stock market outside the U.S. are cheaper based on their 12-month forward price-to-earnings (P/E) ratios. For example, the MSCI EAFE index is trading at 13.7 times 12-month forward earnings as of Monday, while the MSCI Emerging Markets index is trading at 11.6 times forward earnings, compared with a forward P/E ratio of 20.4 for the S&P 500, according to FactSet data. 

U.S. stocks were edging higher on Monday. The S&P 500 and the Dow industrials remained nearly flat, while the Nasdaq Composite was rising 0.2% in the early-afternoon trading, according to FactSet data.