Published July 19, 2024
Very recent stock market commentary has talked about the imminent (in the minds of investors) interest rate cuts by the Federal Reserve. We found the below overview from Blake Millard to be a helpful review of the historical impacts of prior cuts. Interest rates do not play a role in our models. However, as we’ve seen substantially over the past few years, they play a heavy role in how stocks are valued – thus impacting our model signals “downstream”.
“With the all-important Fed meeting on July 31, investors are reviewing what has happened to the stock market around 1st Fed rate cuts and during easing cycles – given the expectation that Fed Chair Jerome Powell will signal the 1st rate cut is coming in September.
Stocks, as represented by the S&P 500 index, have generally rallied in the 3-6 months leading up to the 1st rate cut, which makes intuitive sense because the market is a forward-looking discounting mechanism.
After a short period of consolidation around the interest rate policy change itself, stocks then tend to rally for 6-7 months with a mean gain of ~9-10%.
The key for the market and investor’s expectations will be the risk of recession.
Assuming the base case of no-recession plays out in 2024 and 2025, the market should continue to move higher – using historical analogs as a guide.
For our more data-driven readers, here is the underlying data over the past 12 easing cycles from start to finish.
Source: iCapital, Ned Davis Research
The impact of a 1% rise or fall in interest rates
When interest rates rise by 1%, bond prices tend to fall. The inverse is also correct; when interest rates fall by 1%, bond prices rise.
This inverse relationship between interest rates and bond prices is known as interest rate risk.
But these relationships are not exactly 1-to-1 – things like duration, convexity, and other nerdy input factors must be considered, but that’s for another discussion at a different time.
In the graphic below, J.P. Morgan captures this relationship between bond prices and interest rates in rather simple mathematical terms, showing the asymmetric movement in bond returns at these higher interest rate levels.
Assuming a parallel 1% move in interest rates higher and lower from current rates, here is how different sectors across fixed income would perform.
For example: a 1% rise in rates would cause Investment Grade Corporate bonds to fall -1.8%, while a 1% decline in rates would create a positive return of +12.2%.
This asymmetric risk/return for bonds is why so many bond managers are giddy about the forward prospects in credit and interest rate sensitive instruments.
Source: J.P. Morgan
Moving closer to net accommodation
Over the last several months, many major central banks have pivoted towards interest rates cuts – many doing so for the 1st time since the pandemic.
The share of the world’s central banks in easing cycles has now climbed to 41%, the highest since March 2022.
As shown in the cutout table in the chart below (see the blue arrow), when more than half of the world’s central banks are in easing cycles, it’s historically been a bullish condition for global equities. Equity gains are substantially higher and stronger when more banks are doing QE than not.
Source: Ned Davis Research
Market Update
Volatility picked up this week as markets begin to ponder election outcomes, quarterly corporate earnings reports, and the long-awaited reduction in Fed interest rates expected in September. Monday brought a +0.3% increase in stocks in a continuation of the recent shift in favored market sectors. Interest-rate-sensitive stocks have ripped higher on recent inflation reports showing weakening prices, thus paving the way for the Fed to finally begin cutting short-term interest rates. Small-cap stocks roared higher Tuesday rising +3.5% as the dramatic rotation in stock sectors accelerated. June retail sales came in unchanged from the month before, continuing the strong showing by consumers. The S&P 500 index ticked higher by +0.6% to another record close. Then, the bottom dropped out. Semiconductor stocks were hit hard with the Nasdaq 100 (QQQ) losing -2.8% Wednesday; its biggest drop in 30 months. A double-whammy of political risk hit the group when Donald Trump suggested that Taiwan might see a reduction in U.S. military protection while the Biden Administration mentioned pushing for more restrictions on chip sales to China. Taiwan is a major global semiconductor manufacturing hub. Meanwhile, value stocks rose for a 9th consecutive day as investors shift assets out of growth sectors. Speaking of Taiwan, TSMC, the nation’s chipmaking behemoth, reported a jump in profits and turned the tide back to positive for some semiconductor stocks Thursday. But it was a slim bright spot in a broad down day with the S&P off -0.8% as selling in tech shares spread to other areas. The Nasdaq fell for a third straight day Friday with the index down -0.9%. Cybersecurity company Crowdstrike released a software update that somehow brought down technology systems worldwide. That put markets on their back foot from the open of trading with buyers unable to do anything more than keeping things flat for the day’s remainder. The S&P slipped -0.7%.
Operating parallel to all of the above, recent prediction polls for the November election increasingly show a possible “red wave” whereby Republicans take control of both Congress and the White House. Such an event raises the likelihood that the 2017 tax cuts get renewed or even enhanced thus reducing corporate taxes. That would be a benefit to corporate profits, of course, while the resultant expansion in government deficits could push interest rates upward. The market is also weighing the possibility of a Republican-led government increasing tariffs, thus potentially raising inflation by adding more cost to goods acquired from abroad. Obviously, there is a lot of time between now and the election, much less what policy changes will be enacted. Nevertheless, recent days have seen the first significant influence of the election on market prices, a result of a reduction in perceived election uncertainty.
Volatility soared this week leaving the S&P 500 nursing its first significant weekly loss in three months. The index was down -1.96%. The Nasdaq 100 (QQQ) was hit by broad selling tumbling -3.96%. Smallcap stocks continue to benefit from a rotation out of tech stocks. Despite a drop late in the week, the smallcaps gained +1.74% this week.
Warm wishes and until next week.