We would still recommend tilting equity allocations slightly toward the value style because of the duration and magnitude of the growth rally, which has left value stocks attractively valued in our view. Our positive financials sector view also points to a potential reversal of the growth rally. However, we recognize the counter arguments. Growth may get a boost from the anticipated Fed rate cut and is enjoying strong momentum from a technical analysis perspective. As a result, we suggest keeping any value tilts small.

Small Caps Vs. Large

Turning to market capitalization, let’s look at what a Fed rate-cutting campaign may mean for small cap stocks relative to their larger counterparts. Again, we refer to analysis by Ned Davis Research that reveals some interesting trends [Figure 2]. First, we see that over the past year the relationship between small caps and larger cap stocks has generally followed the no-recession path with small cap stocks underperforming large caps. If this relationship were signaling recession, small and large cap stocks would have produced more similar returns over the past year.

Based on historical performance after initial Fed rate cuts, the chart shows a big divergence between small and large cap performance, particularly when breaking out recessionary and non-recessionary periods. Small cap stocks historically have done better after initial Fed rate cuts that occurred during recessions [Figure 2]. That may seem counter-intuitive, but the best time to invest in small caps historically has been during an economic contraction when markets began to sniff recovery. That doesn’t mean small caps can’t do well any other time, but they typically have performed best early in economic cycles. As the economy has slowed and the Fed has begun to lower rates, large caps typically have performed better.

If we assume we are in the non-recession scenario—our base case—then small cap underperformance experienced over the past year, as shown in Figure 2, may continue. That is consistent with our existing tactical view, in which we have favored large caps over small because of the aging economic cycle. In addition, we see a potential trade agreement with China later this year as a possible positive catalyst for the largest and most global companies. We continue to recommend suitable investors consider maintaining only very modest exposure to small caps, with much larger large-cap allocations at or above benchmark levels.

Sector Implications

The most obvious sector impacted by the Fed is financials, although Ned Davis Research has pegged financials as a market performer after initial rate cuts historically. Still, we believe attractive valuations, increasing dividend payouts, a continued favorable regulatory environment, and the potential re-steepening of the yield curve (meaning short-term rates would potentially fall back below long-term interest rates) could benefit the big banks, which generally posted good earnings over the past couple of weeks.

The best performing sectors after initial Fed rate cuts have historically been consumer staples, healthcare, and industrials. We prefer industrials from this group. Again, large cap stocks have tended to do better as economic cycles aged, and more defensive sectors generally fared well too. We continue to wait for healthcare valuations to fall further amid election-related policy risks before considering a more positive stance toward that sector. We do not believe the cycle is close enough to its end to recommend one of the most defensive sectors—consumer staples. Finally, technology’s track record around initial rate cuts has been mixed, but we like the sector’s growth opportunities enough to maintain our positive view.

Though it’s not a sector, also consider that Fed rate cuts may take some wind out of the U.S. dollar’s sails, which could support currency-sensitive assets such as emerging markets (equities and bonds) and gold. We have a positive view of emerging market equities, and we’re warming up to gold.

Conclusion