Fed’s Rate Cuts May Prove Insufficient To Support The S&P 500 Higher

The S&P 500 has climbed 17.82% so far this year, and the rally has mainly been driven by increasing expectations of an extremely dovish Fed and a trade deal with China. Lately, none of these factors are offering favorable developments. Amid a slowing global economy and trade tensions undermining corporate earnings, many investors are dependent on further rate cuts to justify higher prices for the S&P 500. However, market participants are getting overly optimistic in believing rate cuts will drive the equity market higher going forward.

Forward PE Multiple Expansion

One of the main reasons rate cuts are considered bullish for stocks is because it allows for valuation multiples expansion. More specifically, the yield on Treasury securities is often considered the risk-free rate that is used to discount future earnings, cash flows and dividends in various financial models. Hence, a lower discount rate leads to higher Net Present Values for stocks, therefore resulting in the expansion of valuation multiples.

However, the market has already been pricing in looser monetary policy conditions from the Fed since Jan. 4, 2019, when Powell expressed the need for a “patient” approach to monetary policy. Between Jan. 4 and now, the Forward PE multiple for the S&P 500 has expanded from 14.1 to 16.8. Hence, the multiple has expanded by 19.15% over this time period, and the main catalyst for this has been the increasingly dovish communication from the Fed; raising expectations of multiple rate cuts this year. Hence, given that such profound multiples expansion has already materialized, expecting even further multiples expansion amid actual rate cuts from the Fed is irrational. Keep in mind that the current Forward PE multiple of 16.8 is well above both the 5-year average of 16.5 and 10-year average of 14.8, which means the market is already quite expensive and the forces of ‘mean reversion’ back to long-run valuation averages would make this an unfavorable time to buy into the S&P 500.

Moreover, while the Forward PE is already appearing expensive compared to historical averages, in reality the ratio is actually even higher than 16.8, as I believe current earnings estimates for 2020 are too optimistic. Presently, S&P 500 earnings growth for Q1 and Q2 2020 are expected to be 9.2% and 12.6% respectively. These optimistic estimates are dependent upon various factors, including looser monetary policy conditions being able to reaccelerate economic conditions, a weaker US Dollar, and a US-China trade agreement. All of these assumptions appear highly unlikely.

Firstly, President Trump and Xi have proved that the June trade truce, and any trade truce going forward, can be considered meaningless, as Trump has placed another 10% tariff on the remaining $300 billion worth of goods imported from China. Hence, any potential trade deal in the near-term is improbable, which will force earnings estimates for 2020 lower from current levels.
Secondly, the Fed is taking a less dovish stance than other global central banks, as Powell downplayed the notion of the start of a rate-cutting cycle following the Fed’s 25 basis-point cut on Jul. 31. As a result, the Dollar is likely to remain stronger against global currencies such as the Euro, which will be another headwind to earnings going forward, and also implies that current estimates are too lofty.

Furthermore, in the recent press conference, Powell made clear that the Fed has not dealt with such trade tensions previously, and thus the effectiveness of the recent rate cut at mitigating the negative impacts of the trade war is ambiguous. The Q2 2019 GDP report revealed that business investments dropped 5.5%, and the ongoing trade uncertainty has been a major culprit behind it. Given that there is no end in sight for the trade uncertainty with major trading partners such as China and Europe, it is doubtful that a quarter-point drop in borrowing costs would be enough to successfully induce businesses to engage in large-scale investments. Just like how rate cuts back in 2007/2008 proved ineffective at avoiding the inevitable financial crisis, the Fed’s rate cuts this time round will also prove ineffective to boost business confidence and expenditure this late in the cycle, as they are likely to wait until trade uncertainty has faded and the economic outlook turns more favorable. The Fed is shooting in the dark, which could result in the central bank running out of bullets when they are needed most. Therefore, the inability of the Fed to adeptly support the economy amid the ongoing trade war and global slowdown will further deteriorate corporate earnings, making it more difficult for the S&P 500 to continue rallying higher.

Reference To Previous Rate Adjustments

Following the recent rate cut, Powell made reference to previous instances when the Fed made “mid-cycle adjustments”, and how the Fed has successfully supported the economy/ financial markets by doing so in the past. His reference was most likely to 1995 and 1998, both periods when the Fed cut rates three times to support the economy. As a result, market participants believe the Fed could cut at least two more times to combat the slowdown. In fact, back in the 90s the equity market had roared higher following the Fed’s rate cut adjustments, which is further encouraging the bulls to turn more bullish this time round. However, there are several differences between then and now that investors should take into consideration.

Firstly, back then the Fed funds rate hovered around 5%, which gave the Fed plentiful ammunition to allow them to cut three times. On the other hand, presently the Fed funds rate is still very close to the zero-bound by historical comparison (2%-2.25%), and thus the central bank has much less room to deliver “mid-cycle adjustments” to sustain the expansion, as they would be risking running out of ammunition when a recession hits. Therefore, investors could be disappointed by not receiving as many rate cuts as are being priced into the market, setting the S&P 500 up for a downturn and a reversal of the multiples expansion. Alternatively, the Fed could indeed cut rates a few more times to try and support the economy, but fail to lift the economy/ financial markets higher amid worsening global trade conditions, in which case fed rate cuts would not only prove ineffective, but the loss of confidence in the Fed in dealing with economic obstacles could aggravate uncertainty and put bearish pressure on equity prices.

Secondly, this time is also different given that we are in the 11th year of the economic expansion, and hence are at a much later stage than we were in 95’ and 98’ (during that particular economic cycle). Therefore, extending the expansion through rate cuts at this point in the cycle is likely to be more challenging than it was back in the 90s.

Furthermore, it is interesting to note that back then the Fed was a lot less transparent, as there were no Fed statements released, nor were there press conferences following monetary policy meetings. Whereas today, the market analyses Fed statements and press conference transcripts thoroughly to gain clues about possible future moves. Recently, this greater transparency has actually been working unfavorably, as Powell appeared confused when trying to justify the rate cut, and also ended up disappointing markets by downplaying the notion that this was the beginning of a rate-cutting cycle. Increased transparency and communication from the Fed has actually opened the window for communication mishaps, unintentionally inducing market downturns. Back in the 90s, the markets would not receive any forward guidance from the Fed, reducing the possibility of major market disappointments through miscommunications. Therefore, this era of forward guidance is leading to markets pricing in rate cuts that may or may not happen, which in fact is pulling forward any returns following potential rate cuts, which further undermines the case for taking bullish position on stocks in anticipation of more rate cuts from the Fed.

Bottom Line

The market has already been pricing in multiple rate cuts, leading to an expensive valuation for the S&P 500 in terms of Forward PE, which currently stands at 16.8. Amid worsening global trade conditions and a weakening global/domestic economy, the lofty corporate earnings estimates are likely to be revised lower, and the current forward multiple is probably understating how expensive the market currently is. While Powell is attempting to adeptly sustain the economic expansion through a “mid-cycle adjustment”, similar to how the Fed had done during the 90s, there are notable differences between then and now that could undermine the central bank’s efforts, and make rate cuts ineffective at dealing with the implications of deteriorating trade relations with major trading partners. Therefore, investors should not rely on looser monetary policy conditions from the Fed to drive the S&P 500 higher, as lower interest rates will not be sufficient to support the economy and market higher.