Will a Fed rate cut support markets? At first, yes, but…
Financial markets consider a rate cut at the next Federal Open Market Committee meeting on July 31 a foregone conclusion. There is only some uncertainty about the size of the move, although—after some recent backpedaling from Fed officials—futures markets currently assign an almost 80% probability to 25 basis points, with the remainder pointing toward 50 basis points.
Market Reaction will depend on reason for cut
How stock markets react will depend on what is perceived as the underlying reason for the move. At the moment, sentiment seems to lean toward a so-called ‘insurance’ cut to prevent a slowdown in the current expansion, in which case share prices could continue to rise—at least for a while. A ‘reactive’ cut, on the other hand, could augur the onset of a market downturn. We performed a number of stress tests to assess the potential impact of each scenario on US share prices.
Historic cycles provide range of precedents
The three most recent rate-cutting cycles (1998, 2001 and 2007) provide a good range of scenarios for our analysis. We simulated the performance of a US large-cap equity portfolio, based on historical factor and stock-price movements, using the stress-testing capabilities of our Axioma Risk™ platform. We split each analysis period into an initial market reaction over 1 month and then a 3-4-month horizon. We also broke down the simulated performance by sector, to identify any divergences between cyclical and defensive industries.
Share prices continued to rally after the 1998 'insurance' cut...
When Alan Greenspan lowered interest rates by 25 basis points in September 1998—followed by two more downward steps in the subsequent 8 weeks—financial markets around the globe were still firmly in the grip of the dotcom mania, and the rate moves were simply seen as insurance against the potential fallout of the Asian and Russian crises. Consequently, share prices continued to rally for another 18 months, during which the central bank reverted to tightening monetary conditions by raising rates again by a total of 1.75%.
...but fell soon after 2001 and 2007 downward rate moves
By the time the Fed began to lower rates once more in January 2001, share prices had already dropped by more than 20% from the peak of the technology bubble. Despite a rapid succession of 11 downward moves for a total of 4.75%, the initial recovery of share prices was only short-lived and markets quickly resumed their descent. A similar pattern was observed 6 years later, when hints of the Global Financial Crisis were already beginning to show—though not yet fully recognized for what they were—by the time the central bank made its first pre-emptive downward move in September 2007.
The first reaction is positive - but not for long
These observations were confirmed by the results from our historical stress tests shown in the table below. The 1998 scenario reflects the fact that share prices continued to rise beyond the first positive reaction that occurred in all three environments. However, when looking at the slightly longer horizon, we can see that markets more than lost their initial gains over the subsequent 2-3 months in 2001 and 2007.
Defensive sectors outperform cyclical stocks in a downturn
Another interesting observation is the consistent performance of cyclical versus defensive sectors across all scenarios. In times of rising share prices, cyclical sectors—such as IT, Consumer Discretionary and Industrials—persistently outperformed their defensive peers. But when markets turned, less risky industries—such as Utilities, Consumer Staples and Healthcare—were much less severely hit.
Market sentiment indicates an insurance cut...
A large part of the remarkable performance of the US stock market since the start of the year has been attributable to the perception of the Federal Reserve Bank being “ahead of the curve”. This seems to confirm that markets do, in fact, view the upcoming move as an insurance cut. Another strong indication is the size of the anticipated move. In 1995 and 1998, when the Federal Reserve lowered rates to protect the US economy from the potential impact of the Latin American, Russian and Asian crises, the first rate change was -25 basis points in each case. This compares with an instant 50 basis points in 2001 and 2007.
...but be prepared
Yet, the danger remains that some market participants may interpret the lowering of rates as a sign of an impending downturn, especially if the first move turns out to be -50 instead of the widely expected -25 basis points. In that case, investors may want to prepare for an eventual decline in share prices, even if—as the historical analysis seems to suggest—the immediate reaction to the cut is positive. Stress tests like the ones described here provide a reasonable starting point.
Simulated Returns for US large cap stocks
Source: Axioma Risk™