Chart of the Week

ARE RATE CUTS GOOD FOR STOCKS?

The Federal Reserve is all but certain to commence its rate-cutting cycle this month, following in the footsteps of the Bank of England, European Central Bank and People’s Bank of China, which all lowered borrowing costs over the summer.

This begs the question do rate cuts help or hinder equity markets?

All things equal, lower interest costs should drive share prices higher because they increase the present value of a firm’s future profits and cash flows. Simply put, lower borrowing costs suggest a company will earn more (now and going forward), which makes investing in that firm’s stock more appealing.

The problem is monetary easing tends to emerge when the economy is weak and corporate profits are coming under pressure. During a recession, the decline in a company’s earnings typically swamps the positive discounting effect described above, causing share prices to fall.

That’s why, as the chart below shows, most of the major equity bear markets of the past 30 years have coincided with a US recession (shaded bars).

For much of the past decade, lower interest rates have been a net positive for equity markets, but that’s because there have been no deep and prolonged recessions. Indeed, the 2020 downturn was very short-lived, because of the aggressive policy response, and the 2022 bear market was caused by the Central Banks hiking rates.

Which helps to inform how monetary policy is likely to influence markets going forward.

If a major economic downturn can be avoided, this rate cutting cycle should boost equity markets. However, if growth slows materially or contracts, investors should brace for a meaningful market sell-off.