Expectations that the Federal Reserve will announce more interest rate cuts this week and in the next year have helped boost stocks in recent months, fueling investors' hopes that more market gains are ahead. The S&P 500 Index (SPX) already is up by nearly 20% so far in 2019. However, separate reports from Bank of America Merrill Lynch and Morgan Stanley challenge these bullish expectations.
Instead, strategists at both firms warn that rate cuts, or easier monetary policy, often fail to boost stocks when when the economy is faltering, which is the case today given rising signs that a recession may be on the horizon. “Falling rates are only a positive for equity valuations to a point,” according to Mike Wilson, chief U.S. equity strategy at Morgan Stanley, as quoted in a detailed report by Bloomberg. “We’re passing the point,” he added.
- The Fed is expected to announce another interest rate cut this week.
- BofA and Morgan Stanley see this as potentially bearish for stocks.
- Historically, they find that very low interest rates hurt stock valuations.
- Ned Davis Research disagrees, based on their analysis of history.
- Trade policy could have an even larger impact on stock prices.
Significance For Investors
Particular dangers for stock prices will emerge if interest rates fall near or below zero, which is becoming an increasingly likely possibility. "An ultra-low or negative rate environment is not necessarily supportive of stocks,” warns Savita Subramanian, head of U.S. equity and quantitative strategy at BofAML, in a note to clients quoted by Bloomberg. “The path to 0% would be accompanied by a significant deterioration in the [economic] growth outlook. That doesn’t bode well for P/E multiples,” she says.
Based on their analysis of history, BofAML and Morgan Stanley found different breakpoints beyond which falling yields led to lower, rather than higher, equity valuations. Subramanian finds that stock valuations tend to fall when the yield on the 10-year U.S. Treasury Note drops below 4%. It began trading on Sept. 16 with a yield of 1.9%, and BofAML expects the Fed to lower interest rates about five times by early 2021.
Wilson looked at the real yield on the 10-year T-Note, or the yield after deducting the rate of inflation. He indicates that it currently is in a range between negative 0.5% and zero, a region where an additional drop historically leads to falling equity P/E ratios. Indeed, Wilson points out, after the Fed cut the federal funds rate for the first time in a decade on July 31, the S&P 500 fell by 1.1%, continued to drop in August, and closed on Friday, Sept 13 roughly where it was before that rate cut, at around 3,000.
A contrasting view is offered by Ned Davis Research, based on their studies of stock market performance and cycles of monetary easing across the last century. They find that the second rate cut in a cycle of easing tends to produce a more positive reaction from investors than the first.
“The good news for the bulls, from a historical perspective, is that a reduction next week would mean that a one-and-done cut is off the table,” as Ed Clissold, chief U.S. strategist at Ned Davis, indicated in a note to clients last week, as quoted by Bloomberg. “Two is better than one,” he added.
“Bloomberg Economics expects policy makers to cut rates in steady 25-bp increments until the yield curve is no longer inverted. We believe this means rate cuts in September, October and December," per another report in Bloomberg.
Meanwhile, the Fed's interest rate policy is just one of many factors that will determine the direction of stock prices. "It’s [the stock market] going to be more driven by what we’re hearing on a potential trade agreement,” as Kevin Miller, chief investment officer (CIO) at E-Valuator Funds, told Bloomberg.