The Big What-If: Federal Reserve Cuts and Implications

The potential of Federal Reserve cuts has the market – and finance news – in a frenzy. With seemingly infinite information out there, you’re likely wondering what this means for you and your portfolio. We at Zoe Financial don’t pretend to have a crystal ball, but that doesn’t stop us from attempting to crystallize the present by being data-driven and providing some historical context to today’s environment.

The Trillion Dollar Question: Answered

If the Federal Reserve cuts in July, what can we expect from global asset classes? It is critical to remember that a Fed cut does not operate in a vacuum. We need to see how the global economy holds up while the cuts occur.

Below, we provide two simple scenarios that most closely represent what has occurred in past similar scenarios. The JP Morgan charts depicted look at the average 3-month performance of a broad set of asset classes when the Fed cut and GDP growth accelerated and decelerated over the last 40 years.

Fed Cuts and Growth Accelerates

Not surprisingly, if the Fed cut rates and growth accelerated, Emerging Market (EM) equities outperformed all other asset classes. The recipe of faster global economic growth is a big tailwind for EM equities.

Source: JP Morgan

Surprisingly in this scenario, US bonds slightly outperformed U.S equity, although the data incorporates the 1980s in which bond yields were falling from much higher levels.

Fed Cuts and Growth Decelerates

On average, and in this particular scenario, we see that global equities fell while bonds provided strong performance.

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U.S. Equity and Its Drivers

The two most important drivers for long term equity returns are 1) Earnings growth and 2) Valuations. Let’s take a look at where we stand on both of these pillars.

Earnings Growth

For 2019, analysts project a low single-digits earnings growth of 2.6%. This is compared to the double-digit earnings growth seen in 2018. Thus, we can’t expect U.S equities to be THE driver by this factor this year, despite it being the stickiest and most reliable driver of equity returns in the long term for similar scenarios.

Valuations

That leaves us with Valuations. The issue with valuations as a driver is that it is not a strong predictor in short periods of time (under a year.) In other words, although markets are not “cheap” right now, they can continue to get more expensive for quite a while!

Source: JP Morgan

Especially if the Federal Reserve lowers the cost of capital by cutting interest rates back closer to 0%. As below Seeking Alpha chart shows, there is a negative relationship between interest rates and equity valuation multiples. The lower interest rates are the more investors are willing to pay for a stock’s future earnings and vice versa. 

Source: Seeking Alpha

So…What Happens to the US Dollar?

If the Fed cut rates in July and global growth holds up, it could be the beginning of the end of the dollar bull cycle as both relative growth and interest rate differentials are big drivers for the dollar.

Noteworthy: the current dollar valuations are stretched to begin with, particularly when compared to their real effective exchange rate terms historical averages.

Source: JP Morgan

Money Chase Yields if Fed Cuts

The JP Morgan chart below is a handy and effective resource for evaluating asset class yields globally. For example, note that Asian HY bonds and local EMD bonds will look even more attractive than before if the Fed cut rates.

Source: JP Morgan

The “Aha” Moment

Experience, data-driven research, and well-informed historical background can be helpful tools for contextualizing the current Federal Reserve cuts and potential implications. Having said that, the reality is we don’t know what is going to happen next. The good news is, as below Deutsche Bank chart shows, no one else knows.

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