Rates Got You Down?
Key Takeaways
Rate cuts do not mean that a recession is coming or inflation is going to rise again.
Rate cuts also do not mean that bonds will always rally at the expense of equities as we have just seen over the last couple of weeks.
Whilst there is no certainty in investing, the weight-of-the evidence currently points to 2024 closing out with an ongoing rally.
We will reverse our portfolio positions should markets start to break down unexpectedly.
"Interest rates are like my ex—hard to understand and always rising!" — Unknown
Unlike the quote above, we all now know that the US Federal Reserve has lowered interest rates by 0.5% during their September 2024 meeting. With its first rate cut since the COVID-19 pandemic, the FOMC decided to go big — bigger than the 0.25% which most investors expected.
Central banks cut rates because of a financial crisis or a slowing economy but this stimulative action does not mean that it should happen because a recession is on the horizon.
So far, stock markets have responded positively (pink line), but interestingly, bonds (blue line) have not started to rally as expected by many.
This runs counter to what the vast majority of investment strategists and financial institutions were saying - that rate cuts would be good for fixed income. Short-term rates had already been above long rates for some time, and rates have been slowly coming down over the course of the year in anticipation of the cut. Ask any homeowner who is looking to refinance - we are sure that they have received favourable quotations lately.
Whilst all of this can well reverse over the next few months, this episode highlights that it is really impossible to predict the direction of market prices even when you have a perfectly logical thesis.
When we look to history for evidence of what happens during a rate cut, the vast majority of easing measures have been positive for stocks (as shown by the performance of the DJIA) in the chart above.
Looking at the factors that could have possibly driven equity market returns, it appears that on average, earnings per share for companies actually declined. Despite this, the stock market rose up to 12 months after the first rate cut. What could this possibly mean?
Positive sentiment that generates positive momentum seems to be the driving force behind the rally. Investors could also be trying to get into stocks with a view that the future could be more positive.
When we look at the performance of bonds following the first rate cut, the picture becomes a little more clouded with a wide variation in returns. At best, the average (dark blue line) bond performance is flat after a rate cut.
However, in investing things can always flip around. Whilst we cannot really predict how stocks and bonds will move, what is certain from the lowering of interest rates is that the interest on your savings accounts, fixed deposits, money markets and T-bills will drop. If you are looking for a loan, then borrowing costs should fall as well.
Investing involves no guarantees. And for our investment philosophy, we like to use weight-of-the-evidence approach. Essentially we like to err on the side of statistics - making decisions based on high probability outcomes. When the market trend is positive (chart above), we have a supportive interest rate environment, and the risk of recession is low, then the returns of stocks have traditionally been strong.
As we approach the early stages of October, we should be exiting the weak seasonal stretch soon and the likelihood that we close out the year with a year-end rally is high. However, we do not want to be wedded to a single point of view. We will be quick to reverse our allocations and turn conservative if necessary if the ongoing Middle East conflict were to abruptly throw a spanner in the wheel of the global economic cycle or if the euphoria surrounding AI were to suddenly implode and trigger the next financial crisis.
If you would like to find out more about our current investment perspectives, come and chat with us.
