With a certain Fed rate cut on the horizon for September, here’s how it could impact your investments.
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Is a September Interest Rate Cut by the Fed All But Certain?
Federal Reserve Chair Jerome Powell conveyed a clear message on Friday, August 23, stating that "the time has come for policy to adjust." Several Fed officials indicated they would have supported a rate cut at the July meeting. While rates were maintained in July, the data-driven approach suggests easing could continue through the end of 2024, potentially including three 25-basis-point cuts. Concerns over rising unemployment and cooling inflation have fuelled the debate, with the Fed closely monitoring economic conditions before making further decisions.
Conclusion: Yes. We consider the probability of a September interest rate cut to be nearly 100%. Powell’s message has removed any remaining doubts about a September cut. The July CPI report, showing a 3.2% year-over-year increase in Core CPI, supports a 0.25% cut without indicating a significant drop in price pressures that would necessitate a larger 0.50% cut. We estimate a 70% chance of a 0.25% cut and a 30% chance of a 0.50% cut, with a 0.25% reduction being the most likely scenario.
Do Lower Interest Rates Boost Business Valuation?
Decreased interest rates significantly impact business valuation, both in terms of WACC and Free Cash Flow.
On the WACC level, the risk-free rate is often based on the yield of 10-year Treasury bonds. When interest rates decrease, the yield on Treasury bonds typically decreases as well, leading to a lower risk-free rate and, consequently, a lower WACC. Lower interest rates also indirectly affect beta: in a low-interest-rate environment, investors might shift toward riskier assets, affecting market volatility and a company's beta. Furthermore, with lower interest rates, companies might take on more debt (increasing leverage) since borrowing costs are cheaper. This typically reduces the WACC, as more weighting is allocated to the cheaper cost of debt rather than the cost of equity. Since DCF involves discounting future cash flows to the present using WACC, a lower WACC increases the present value of future cash flows, leading to a higher valuation.
On the Free Cash Flow level, lower rates can stimulate economic activity, potentially increasing revenues and cash flows for businesses. Additionally, lower borrowing costs can make it easier for companies to finance new projects or capital expenditures, potentially leading to higher future cash flows.
Conclusion: Yes. Decreased interest rates generally lead to a lower WACC, which increases the present value of future cash flows in a DCF analysis, thereby boosting the overall valuation of a company. Additionally, potentially higher cash flows further enhance valuation.
What Does This Mean For Stocks?
Let’s examine past Fed rate-cut campaigns. According to a report by Schwab, in 12 out of the Fed's 14 rate cycles since 1929, the S&P 500 delivered positive returns 12 months after the initial rate cuts. Please refer to the graph below.
The only two exceptions occurred after the Fed began lowering rates in 2001 and 2007. “They may feel uncomfortably recent, but neither economic environment resembles today's,” the report noted, highlighting the dot-com bust and the subprime mortgage crisis as the driving forces behind those downturns.
Conclusion: Predicting market performance with certainty is challenging. Historical trends suggest a tendency for positive returns following rate cuts, but each economic situation is unique. Factors such as economic conditions, U.S. elections and global events can influence market outcomes differently. In the absence of major shocks, a modest increase in index quotes is likely.
Is It Possible That Investors Have Already Anticipated The Rate Cut?
It is indeed possible that investors have factored in expectations of the rate cut into current stock prices. If the market has fully priced in the anticipated decrease, the actual rate cut might not result in significant price movements, as the news is already reflected in valuations. Consequently, the impact of the rate cut could be muted if investors have adjusted their positions in advance. However, while significant rate cut expectations might be incorporated into current quotes, the extent to which this is accurate can vary depending on market conditions, investor sentiment and new economic information. Even if a rate cut is widely anticipated, market reactions can still be volatile due to other factors or unexpected developments in accompanying economic data.
Conclusion: Yes, but to an uncertain extent. While expectations of a rate cut may already be factored into current stock prices, the actual impact on the market could still vary. If the rate cut is anticipated and priced in, its effect might be less pronounced. However, market reactions can remain unpredictable due to evolving economic conditions and unforeseen developments.
Do All Stocks Benefit Equally from Interest Rate Cuts?
When interest rates are cut, stocks in cyclical sectors often see greater benefits compared to those in defensive sectors. Lower interest rates generally stimulate economic activity by encouraging consumer spending and investment, which in turn boosts sectors that thrive in a growing economy. For example, consumer discretionary stocks, such as automobile companies or retailers, and industrials, like construction equipment manufacturers, tend to perform well as the economy accelerates. These sectors benefit directly from increased consumer spending and capital investment, which are more likely when borrowing costs are low.
In contrast, defensive sectors - such as health care and utilities - are known for their stability and resistance to economic fluctuations. Companies in these sectors, like pharmaceutical giants or utility providers, often provide steady returns and reliable dividends, making them attractive during periods of economic uncertainty. However, their performance is generally less sensitive to interest rate changes. While these stocks can still perform well when rates are cut, their gains may not be as pronounced as those in cyclical sectors, as they do not rely as heavily on economic growth to drive their profits.
Some sectors might experience dual effects. For example, banks and financial institutions might initially suffer as lower rates compress profit margins on loans and reduce net interest income. However, they could benefit from increased borrowing and economic activity in the longer term.
Conclusion: Not all stocks benefit equally from interest rate cuts. Cyclical stocks, which are more tied to economic growth, typically see more significant gains as lower interest rates boost consumer spending and investment. In contrast, defensive stocks, known for their stability, may experience more muted benefits since their performance is less dependent on economic cycles.
What Should You Do Now Ahead of the September Cut?
General advice would be as follows:
Consider increasing positions in consumer discretionary, industrials and financials.
Maintain some liquidity to capitalize on any opportunities from unexpected market reactions.
Pay attention to statements from Fed officials for insights into the magnitude of the rate cut.
Set stop-loss orders on more volatile positions to protect against market swings.
If you have a specific idea in mind beyond these general actions, don’t hesitate to approach us for informed investment decisions. At Nesterovs Advisory, we actively support investors with fundamental analysis to help identify securities with current quotes below their fair value estimates.
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