Equity investors should take no comfort from the likelihood that the Federal Reserve will continue to cut interest rates.
Simple statistics tell us this. Since 1996 there has been a strong positive correlation between annual changes in the All-Share index and in the Fed funds rate, of 0.57. Cuts in US interest rates are far more likely than not to be accompanied by falling share prices – as we saw, for example, in 2001-02 and in 2007-08. Conversely, some of the best gains in equities have come when the fed funds rate has been rising, such as in the mid-2000s or in 2016-17.
One obvious reason for this is that rates fall when the US economy is doing badly. And this is bad for equities not just because it cuts corporate earnings but also because it reduces investors’ appetite for risk. Since 1996 there has been a strong correlation (of 0.59) between annual changes in the All-Share index and in US industrial production. This explains why equities haven’t done much in the past 12 months: it’s because US industrial production has fallen slightly.
Even if we control for changes in US output, however, it is still the case that cuts in US interest rates (and falls in bond yields too) are associated with falls in UK equities. This is because rate cuts send a signal – that prospects for the US (and hence global) economy are poor. And these are circumstances in which shares do badly.
There’s a lively debate among economists about how much looser monetary policy can do to boost economic activity. Even if it can do so, however, equities would take little joy in this fact and would instead worry more about the fact that the economy is so weak as to require lower rates.
The idea that loose monetary policy can support share prices is, therefore, refuted by recent history. Any equity rally caused by rate cuts is likely to be weak and short-lived. It is not interest rate cuts that would lift equities, but something else – any signs that the US will avoid a recession.
Which poses the question: where did the idea that interest rate cuts are good for equities come from?
As with so many bad ideas, it is from our youth. The strong link between US output growth and equity returns has only existed since the mid-1990s. Before then, cuts in interest rates – even during times of economic weakness – were sometimes good for shares. For example, US output and interest rates fell in the early 1990s but equities rose nicely.
Could this history repeat itself?
I doubt it. What we have here is a rare example of those dread words actually being true: this time is different. The difference is: inflation.
From the 1970s to early 1990s economic growth was ambiguous for equities. On the one hand, it raised earnings and investors’ appetite for risk. But, on the other hand, it raised the fear of inflation and of higher interest rates, and hence the prospect of lower growth or even recession. Conversely, weaker growth reduced inflation and interest rates and hence made investors more optimistic about the future. On balance, the impact of economic growth on equities was therefore weak.
In recent years, though, the threat of inflation has been absent. The fact that US wage inflation has fallen this year despite unemployment being at a 51-year low tells us that this remains the case. As David Blanchflower, a former member of the Monetary Policy Committee, writes in his new book, Not Working: “the relationship between the unemployment rate and wage growth that existed pre-recession has been broken, apparently irretrievably”.
This means that any pick-up in growth would be a good thing. If we get it, investors won’t think – as they did in the 1970s and 1980s – that there’s a threat of inflation. They’ll just be relieved that we’re escaping recession.
And escaping recession is just what most economists expect. Both the Federal Reserve and OECD expect the US economy to grow by around 2 per cent next year, only slightly less than this year.
Sadly, this is not as comforting as it seems. The IMF’s Prakash Loungani has shown that forecasters consistently fail to see recessions coming. Even if we are on course for recession, therefore, history suggests that economists won’t tell us in advance – although of course this does not mean we always get a recession when they predict growth.
Nevertheless, the fact remains. It is economic growth, and not interest rate cuts, that is the best hope for equity investors. If you are looking for rate cuts to support equities, you will probably be disappointed.
