Deutsche gives three reasons why an interest rate cut will not do much for the stock market:
1. The RBA is unlikely to deliver sizeable cuts. Previous rate-cutting cycles have been 200bp+, and rates markets are priced for only ~110bps over the next year. Economists are even less dovish, seeing no change over the next year (DB at 50bps), and this view gains support from the recent run of solid data.
2. We look at the 4 rate-cutting cycles over the past 20yrs, and find that equities do not pick up until ~1yr following the first rate cut. This is likely because rate cuts have a lagged impact, and earnings weakness weighs in the near term.
3. On a sectoral basis, defensive industrials actually outperform for the first 3-4 months, and then cyclicals begin outperforming. This again relates to the lag in rate cuts affecting earnings. (Meanwhile, banks outperform throughout.)
That is based on historical analysis during more “normal” times. The effect is likely to be even less strong in such a parlous period for global markets. It may be true that if interest rates fall investors have fewer effective safe havens and so look more at safe stocks with high dividends. But there is also the risk highlighted this morning by Rick Battelino of the RBA that consumers’ saving is now structural so any rate cuts will have a muted effect and may, in fact, result in accelerated debt repayment.
Deutsche notes that defensives tend to thrive from rate cuts. This is even more likely in the current conditions:
On a sectoral basis, defensive industrials actually outperform for the first 3-4 months following rate cuts. This likely reflects the impact of an worsening earnings environment, which of course is the very reason that the RBA decides to cut interest rates. While lower rates have an impact in time, in the first few months softer earnings led investors to stay away from cyclicals.
This analysis would suggest that investors are best to use the months after the first rate cut as opportunities to buy up sold-down cyclicals, in anticipation of a bounce over the following year. Looking at the past four rate-cutting cycles, cyclicals have outperformed the market by ~15% within a year of the start of rate cuts.
They also argue that banks tend to do well, which of course they do. Surprise surprise, they take time to pass on the cuts, so their profits increase. Interest rate cuts also help the stability of their mortgage books, though if accelerated repayment was the result then they’ll struggle to expand the balance sheet:
Interestingly, banks typically perform strongly once interest rate cuts commence, and this continues for over a year on average. Holding all things equal, rate cuts should be good for banks, as lower interest rates reduce financing burdens for consumers and lower hurdle rates for commercial borrowers. However, as rate cuts usually occur during a period of economic weakness, it is somewhat surprising that those banks outperform from the outset. The exception is the rate cutting cycle in the early 1990s, when banks underperformed the market for around 18 months following the first rate cut.
The problem, as I have discussed before, is that falling interest rates are equated with stagnation, the disapperance of the cost of capital and all the momentum that implies. It is a signal that is spooking investors around the world, so it is tending to have the opposite consequence to that intended. If the global financial architecture is stabilised there will be a strong buying opportunity, but in the short term the effects could be quite perverse.