Why Investors Should Care About Rate Cuts

by | Aug 1, 2019 | Recent Commentary |

  • To date, about one-half of companies in the S&P 500 have reported Q2 earnings.  Seventy-seven percent of companies have reported a positive EPS surprise, a very strong showing.  The overall earnings decline is expected to be 2.6% for the quarter.  For CY 2019, earnings growth is expected to be a paltry 1.7% but surging to a forecast 11.2% in 2020 – the number that really matters.  Now into August, 2019 is history by Wall Street standards.  2020 looks like it may bring renewed momentum in corporate earnings.
     
  • Yesterday, the Federal Reserve Board cut the Fed funds rate by ¼%, the first cut in over a decade – in spite of our economy being in a “good place.”  Is the Fed delivering yet another sugar high to an economy that doesn’t really need it?  Or is the Fed worried about a slowing global economy and trade tensions that could slow future growth here?  Probably the latter.  Markets are expecting more cuts ahead, but stabilizing economic data (including very strong second-quarter consumer spending) and an uptick in inflation could have FOMC members more inclined towards patience.  Yesterday’s cut was widely anticipated.  In fact, some investors were disappointed the cut wasn’t ½%.  But if a 25 basis point difference in policy rates is going to significantly disrupt an investor’s investment process, perhaps they need a more robust process.  In the section below, we discuss the significance of the rate cut to the markets.

WHY INVESTORS SHOULD CARE ABOUT RATE CUTS

Many investors are aware that stocks perform better when the Fed is in an easing cycle.  Stocks can appreciate when rates go up, too, but the magnitude of the gains is much smaller.  “Don’t fight the Fed” is the old adage.  Now that the Fed is on our side, what can investors expect going forward?
 
The difference in returns by type of cycle as shown below is quite substantial.  The bar chart, courtesy of CFRA, shows historical returns in easing cycles (like we started yesterday) compared to tightening cycles (rising rates).  It is quite an eye-opener.

According to this study, we could see double-digit gains over the next six and 12 months.  But how much of yesterday’s cut has already been baked into share prices resulting in strong YTD gains in stocks?  We certainly won’t know that until later.  But this is why investors have been so excited about the prospects of a new easing cycle.  Yesterday’s cut was widely anticipated with a 100% probability according to market polls.
 
Why do stocks do better when rates are being cut?  Some of the reasons include:

  1. Bonds and other alternative investments to stocks become less competitive.
  2. Lower rates result in lower borrowing costs for companies which incrases their earnings power.
  3. Future earnings and cashflows are discounted at a lower rate, which increases their present value (share prices).

During yesterday’s Fed press conference, stocks accelerated to the downside when Chairman Powell stated this rate cut is a mid-cycle policy adjustment and not necessarily the start of a lengthy cutting cycle.  He later walked that back and said the Fed was not committed to a single cut or series of cuts.  We think the modest policy adjustment is a positive.  It satisfies the investors’ demand for lower rates without signaling a growing sense of urgency by Fed officials.  The Fed will likely offer a second-round cut later this year to support the expansion.