Fed rate cut expectations and stock markets’ rally
Currently, Fed rate cut expectations are driving stock markets’ rally. The S&P 500 (SPY) has gained 17.2% in the first six months of this year—the best first half for the index in 22 years. The Dow Jones Industrial Average Index (DIA) rose 7.2% in June—its best performance in June since 1938. DIA has gained ~15% year-to-date.
Market participants are fairly certain that the Fed will cut the interest rates in its July policy meeting. The only question in their minds is by how much. The stronger-than-expected June jobs report dampened the rate cut expectations. A CNBC report said that based on the CME FedWatch tool, traders are pricing in a 100% probability of a quarter point cut in July.
Powell strengthened the expectations
Today, Fed Chair Jerome Powell is scheduled to testify before Congress. In his prepared remarks, he mentioned that the “crosscurrents have reemerged.” His comment was seen as a signal for a more accommodative policy. Powell’s comment strengthened the rate cut expectations. As a result, the markets hit new highs.
Andrew Hollenhorst, a Citigroup (C) economist, thinks that the Fed will refrain from cutting rates in July. Mark Yusko, a hedge funder manager, thinks that despite the market factoring in a 100% probability of a rate cut, the cut might not materialize.
Rate cut won’t boost stocks
Goldman Sachs (GS) thinks that if the Fed’s interest rate cut happens, it shouldn’t lead to a big increase in stocks. As reported by CNBC, Goldman Sachs’s chief US equity strategist, David Kostin, said that since the market is expecting and pricing in a Fed rate cut later this month, getting one won’t do much. He said, “What new, incremental information are we going to get to push the market higher? The answer is, not a lot.”
Goldman Sachs is predicting two rate cuts in 2019 due to the Fed’s reluctance to go against market expectations. Kostin doesn’t think that the cuts will do much to propel the markets higher. He maintained his S&P 500 (SPY) target price of $3,000 by the end of the year. However, there’s one catch. If the US and China reach a trade deal, the markets could get a big boost. A trade deal in the near future isn’t the best-case scenario for Goldman Sachs.
Earnings could slow down
Goldman Sachs is concerned about a possible slowdown. To learn more, read Goldman Sachs is Worried about an Earnings Slowdown. Kostin is concerned that policy uncertainty and negative 2020 EPS revisions will limit equities’ upside. Kostin also attributed ~90% of the rally in the markets to valuation multiple expansion since the beginning of January. He thinks that the forward PE ratio increased from 14x to 17x.
Cheaper interest rates are related to higher stock market valuations. There needs to be significant progress in corporate earnings for the markets to sustain the current multiples. There’s an uphill battle due to low inflation, low unemployment, and rough global conditions. As we discussed previously, J.P. Morgan has similar concerns. Read Trade Resolution, Easy Fed, and Growth Can’t Hold for Long to learn more.
In Fund Managers’ Allocations Point to Recessionary Conditions, we discussed that a net 41% of fund managers expect corporate profits to deteriorate over the next 12 months. The number reflected a fall of 40 percentage points—the largest one-month drop ever.
Morgan Stanley’s expectations
Morgan Stanley (MS) expects the Fed to cut the rate by 50 basis points in July. However, Morgan Stanley is “underweight” on global equities. As we discussed in Why Morgan Stanley Downgraded Global Equities, Morgan Stanley downgraded its stance from “equal-weight” to “underweight” for equities. Morgan Stanley expects poor returns from stock markets. Over the next 12 months, there’s a 1% average upside left for Morgan Stanley’s target price on SPY, MSCI Europe (IEUR), MSCI EM (EEM), and Topix Japan. Morgan Stanley thinks that monetary easing will be offset by weaker growth. Over the last 30 years when easy monetary policies came face to face with weaker growth, stock returns didn’t improve.