 "Why markets said 'meh' during previous US Federal Reserve rate cuts")
Global markets have largely rejoiced at the US Federal Reserve signal of the first rate cut in September. However, the start of the rate cut cycle cannot be the only reason for the rally, if history is anything to go by. The performance of the Indian and the US markets during the previous rate cut cycle was muted.
The benchmark Nifty gained 4.5 per cent and 1.1 per cent in three months and 1 year after the first rate cut on July 30, 2019.
Meanwhile, the S&P500 of the US rose 1 per cent in three months and 8.1 per cent in a year, according to an analysis by foreign brokerage Nomura on equity market performance during the past six rate cut cycles.
The brokerage concluded that economic conditions that necessitate the cuts and starting valuations into rate cut cycles hold the key.
"We think equity investors should recognise that forward returns are likely to be much more muted given current S&P's valuations (21 times) that do appear on the higher side,” said Chetan Seth, Equity Strategist, Nomura wrote in a note last month. Likewise, the valuation of the benchmark Nifty is also about 21x on a one-year forward basis.
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In four of the past six instances, the S&P has shown positive returns in the three, six, and 12 months following the start of the Fed rate cuts. The exceptions in 2001 and 2007, which coincided with overvalued markets and a severe economic downturn in the US, resulted in negative outcomes for stocks.
In 2001, the S&P 500 was trading at a one-year forward price to earnings (PE) of 20.1, the highest during the start of the previous six rate-cutting cycles. The 2001 rate cuts were driven by the dot-com bust, which coincided with a mild recession and led to significant stock declines.
The 2007 cut cycle was driven by the US subprime mortgage crisis, which culminated in a hard landing and was negative for stocks. Analysts said that if Fed rate cuts are driven amid moderating inflation and a US soft landing, it should not be a bad outcome for stocks.
"When the economy does not do well or if the starting valuation is elevated, then markets don't rally after Fed rate cuts. In the US, in the past month, there has been a change in sectoral leadership. Tech is not doing well now, but banks and small caps, which were not doing well in the US, are starting to do well," said Jyotivardhan Jaipuria, founder of Valentis Advisors.
Experts opine the main reason for Fed cuts also matters.
"Are you cutting rates because the economy is going down really quickly, which then means there is a problem for earnings? At the moment, earnings growth is still there. If the Fed cuts rates ahead because of weaker growth coming forward, then that will be seen as being helpful to keep growth going. So rather than being reactive and waiting for the economy to go into recession, you are cutting quickly ahead of that," said Andrew Holland, CEO of Avendus Capital Public Markets Alternate Strategies.
Holland said it is a bit more challenging to assess the outcome of the Fed cut this time due to the US elections.
The performance of Asian stocks was mixed across markets and periods during Fed cuts. The Nifty declined in three, six, and twelve months after the 2001 rate cut. In 2007, it fell on a 12-month basis post-rate cuts, and in 2019 the returns were muted.