Could equity bulls be right about rate cuts?

By Zac Tate, Hottinger Investment Management

A new conventional wisdom has emerged in recent weeks among people who want the equity bull market to run on and on, and it goes like this: The rally in global bonds and race to loosen monetary policy may be reactions to slowing global trade and activity passing through to sluggish earnings, but this does not mean that the great bull market in equities must come to an end. On the contrary, this view holds that lower bond yields boost valuations and should allow the party to keep going.

Usually, when central banks cut rates it is because economies are in ‘late-cycle’, which means growth starts to slow and company earnings soften. It is usually too late for central banks to stop this deceleration and their cuts to interest rates often kick in only once the economy is in a state of recession. Equities therefore typically fall as rates go down, which is evident in the charts below for two periods in the 2000s. In other words, during ‘late cycle’, there is a negative correlation between the total returns of bonds and equities.

Figure 1: This chart shows the performance of the S&P 500 index in the period following the beginning of interest rate cuts in 1998, 2001 and 2007. At the beginning of each period, the S&P 500 is indexed to 100% and performance thereafter is relative to this level. The chart therefore shows that after the 2001 and 2007/8 rate cuts, it took over five years for the S&P to recover to its pre-cut levels.

People who hold this view are implictly saying that the positive correlation between total returns of stocks and bonds – something we have not seen much during the period of independent central banking – could be here to stay. They could be right. Although we are not convinced, it is worth mentioning four reasons which may support their case. While they may not be right today, they could be in the not-too-distant future.

The first is that recent US history shows rate cuts can coincide with sustained expansion in US equity markets. When the Federal Reserve cut rates in the mid- and late-1990s, first amid concerns of growth slowdown and then to fight any contagion from the Asian financial crisis and the Russian debt default, equity markets continued to rally. In 1995, the then Fed Chairman Alan Greenspan spoke of ‘insurance cuts’: pre-emptive reductions in interest rates to engineer a soft landing for economic growth. It seemed to work; it wasn’t until 2001 that the US next experienced a recession.

We could be in a similar situation today. There is again talk that the Fed will make an ‘insurance cut’ later this month and at least one more in the Autumn, but markets want four such cuts by Spring next year.  As in 1995, when Greenspan speculated that US inflation was “being held down by events in the rest of the world,” today global factors – emanating in China in late 2017 before passing through Europe last year – have acted as headwinds to an American economy that has been growing at above 3% per year for a considerable period of time.

A bout of monetary easing could reveal a US economy that remains resilient to global factors, one that is mid-cycle rather than late-cycle. The Fed would then have successfully permitted the party to go on. Many, however, are skeptical that the US economy has been immune to global events – particularly the trade war; US corporates that have high revenue exposure to China have performed relatively poorly in recent months.

A key reason for the global slowdown reaching the US last is the country’s unconventional fiscal policy – with the Trump adminstration presiding over a pro-cyclical fiscal deficit that recently exceeded 4% of GDP, according to the US Congressional Budget Office. Unconventional fiscal policy is the second factor that could support the idea that equity markets can stay strong as interest rates and bond yields fall.

Fiscal-monetary coordination is a dry phrase describing a concept that is in vogue within international policy-making circles.  Most notably, President Trump has been keen to politicise the Federal Reserve’s activities through the medium of Twitter, but the idea that central banks should work with government treasuries is one that is popular among serious policymakers too.

The incoming ECB governor, Christine Lagarde, has previously spoken about the need for fiscal-monetary coordination. She will play an important role in encouraging European governments to spend more and persuading EU institutions to let them do so. What this means is that lower interest rates could provide the fiscal space for governments to spend more as they would be able to borrow more cheaply. Extra spending could then translate into stronger nominal GDP growth that feeds into earnings and valuations. In this scenario, share prices would rise. We have previously argued that such a switch to policies of ‘fiscal dominance’ could drive inflation in a way that means that stocks and bonds move in the same direction.

The third reason supporting the equity bulls lies in the possibility that central banks will in the future support equity markets directly. There has been speculation that in the event of a serious downturn, central banks may directly intervene in the equity markets by taking stakes in public companies. The Bank of Japan has already implemented such a policy, last year purchasing 5.6 trillion yen ($50bn) in Japanese equity ETFs, taking its total ETF balance to around $300bn. The central bank aims to use ETF purchases to stoke inflation by spurring gains in asset values, as well as promoting active private consumption.

We are not convinced that outright direct equity purchases do more than just aggravate inequality, but governments could design sensible equity purchase policies where their central banks would buy equities when they have suffered a drawdown, sell them as the market recovers and distribute the gains to the public ahead of the next downturn. The point, however, is that this policy would support an environment where rising equity prices could coincide with falling bond yields, as the central bank would be active in both markets.

Lastly, the Federal Reserve is arguably the world’s central bank. Anyone who has read Crashed by the peerless Adam Tooze can appreciate how it was the Fed, not the ECB, which bailed out European banks during the 2008 crash through its liberal supply of dollar swap lines. The Fed’s interest rate policy is also closely tracked by a great many emerging market economies, whether or not they peg their currency to the US dollar.  

Last year, economists Matteo Iacoviello and Navarro Gaston studied the global transmission of the U.S. Federal Reserve’s interest rate policy and what they found was striking. Looking at macroeconomic data covering the period 1965-2016, they found that the effects of monetary tightening from the Federal Reserve on economic growth are almost as strong outside the U.S. as they are within it.

“A monetary policy-induced rise in U.S. rates of 100 basis points reduces GDP in advanced economies and in emerging economies by 0.5 and 0.8 percent, respectively, after three years. These magnitudes are in the same ballpark as the domestic effects of a U.S. monetary shock, which reduce U.S. GDP by about 0.7 percent after two years.”

The authors explain the transmission of US policy worldwide as occurring through standard exchange rate and trade channels, with countries that trade with the US and manage their currencies in line with the dollar more strongly affected. As US rates rise, the dollar appreciates. In countries for which a stronger dollar causes inflation to rise or balance sheets to deteriorate, or where the government has tied its currency to the dollar, there is pressure for interest rates to rise too. As the experience of 2018 showed, emerging market countries with exposure to the dollar, current account deficits and low foreign reserves – such as Turkey, South Africa and Argentina – can be severely constrained by tight U.S monetary policy.

Certainly, then, lower US bond yields and interest rates can be very positive for dollar liquidity in emerging markets (EM). They can support  EM companies’ balance sheets and ultimately asset prices too. Given the growing weight of EM in global markets, there could be positive feedback for US equities too.

So, there we have it. The equity bulls may be right, but we think the rally in global bonds is more likely a reflection of the hard economic data pointing to a moderately slowing world economy, which should be negative for equities as earnings fail to meet ambitious expectations. In time, therefore, equities should come down even as interest rates do too.

However, there are good reasons to suggest that investment dynamics could change in favour of equity bulls over the longer term, but only if the political-economy environment changes too: If the policy regime changes to one involving deep fiscal and monetary coordination, if central banks start directly supporting equity markets, or if emerging markets increasingly become dependent on dollar liquidity delivered through a low interest rate policy from the Federal Reserve, the picture could look very different.