WILL RATE CUTS MAKE A DIFFERENCE TO THE ECONOMY AND THE STOCK MARKET
When it comes to what a company’s stock is priced at in the market, it all comes down to two things: what that company earns and the level of interest rates. For this reason, company stock prices are a reflection of the estimated future earnings and cash flows generated by the company, discounted back to the present at current interest rates (typically the interest rate on a long-dated government bond plus a risk premium). As interest rates decline, future cash flows become more valuable today because of the lower discount rate. Other things being equal, lower interest rates move stock prices higher. As “price” is the numerator of a common valuation metric known as the price-to earnings ratio (P/E,) which compares the current price of a stock to its expected earnings (typically one year forward), the P/E ratio also rises. When the P/E is elevated relative to history, risks become elevated too as there is no room for disappointment. Therefore, earnings reports can be either supportive of that multiple, if they bring no negative surprises, or be quite toxic to the stock price, should the company’s results miss expectations and/or management’s future earnings guidance disappoint.
As far as the economy itself is concerned, when rates are cut this generally stimulates borrowing which boosts the economy through increased consumption. However, generally rates are cut when the authorities feel the need to stimulate economic activity or when employment growth stalls. This is not the problem in the US economy today. Over the last few cycles we have managed to continue to grow out of economic slowdowns by using more and more debt, fueled by easy credit. After a very brief rate hiking cycle, rates are now being cut, as the current debt load proved to be too burdensome and individuals and companies showed early signs of financial stress because of the higher debt servicing costs. However, it is vital to highlight that a reduction in rates does not automatically equate to being able to take on more debt and thus higher consumption and economic growth. For this reason, there is a diminishing marginal return associated with the increasing levels of debt. As more and more cycles are funded by debt, eventually we will reach a tipping point which will require a big deleveraging reset to get out of that debt. The big question is, are we at that tipping point now?
There are currently more companies at risk of becoming financially distressed now than there were during the last cycle peak. This is particularly alarming given we are currently seeing peak margins and profits. What happens when these margins decline or normalize? A lot of these highly indebted companies are in cyclical sectors, such as oil and gas, and are smaller in size. Over 50% are now experiencing negative earnings before interest taxes and depreciation/amortization (EBITDA) or their net debt is at over three times their EBITDA. Is this sustainable? Lower interest rates can only help keep these “zombie” companies alive, for now, but the day of reckoning can only be artificially extended for so long. Unfortunately, these are the companies that are normally also responsible for growth in employment. These companies are currently considered “value” in the market because they are trading at much lower multiples than those that have stable earnings, despite the economic environment. There is always a reason why something trades at a lower multiple. In investing, being cheap is not necessarily value, as the companies that are typically cheap are cheap for a reason, such as potential financial distress.
In Europe, most countries are now offering bonds that pay negative rates. In other words, you are guaranteed to lose money in the one asset class that you are supposed to use to protect your capital. If that was not crazy enough, pension regulations require institutions to avoid excessive cash holdings as these are considered too ”risky” and insist that pension fund managers instead buy these long dated bonds that are guaranteed to lose money. Governments are forcing pensioners into negative returns to fund all the indebtedness that governments took on during the financial crisis, in order to help out those in the private sector that took on more debt than they could handle. This is true financial repression at its worst.
In the end, desperate governments do desperate things. They will do anything to keep kicking the can down the road and improve their chances of being re-elected. But one day, all this debt will matter. There are only three ways to reduce debt load: grow out of it, inflate it away or default. Given the magnitude of the debt levels it is quite possible that we will see some combination of all three. Those that will lose will be investors in these long dated bonds who thought they had saved enough for retirement. Those that will win will be the ones that never bothered to save in the first place, as they figured the government will take care of them. This is what transferring wealth from those that have it to those that do not (and are in debt) looks like. After decades of wealth accumulation, it is likely that we are now entering a period of wealth distribution.
More declines in bond yields are coming in North America, as money seeks those countries around the world that are offering bonds with positive yields and avoids the country debt offering negative bond yields (now amounting to over US $14 trillion globally). However, the paradox is that even if the US decreases rates to zero, other central banks are likely to adjust accordingly by going even more negative as their economic situation is much worse. Lower rates give you a lower currency which makes your country more competitive economically. In the end, this will be a race to the bottom for all world currencies as they all try and outdo each other in order to remain competitive. Even if US rates go to zero, as long as other regions are lower (negative), the USD will remain strong as currency exchange rates are priced relative to each other. There are never many winners in currency wars which can quickly destabilize the financial environment in the process.
Rate cuts may help stock markets in the short term. There is no other place to go in order to provide a sufficient financial return to fund retirement other than to go out the risk curve. The choices are either high yield (also known as “junk”) bonds or stocks that pay higher dividends than the prevailing interest rate. This strategy will work in stock markets as long as the companies that are paying the dividends can keep growing their earnings. If they cannot, either because debt payments take all their cash flow or because demand for their product and cash flow goes down for any reason, then capital losses will more than offset the dividend payments.
The market is increasingly demanding that the US Federal Reserve cut its funds rate another two times this year to stimulate growth. However even with a decade of extremely cheap credit, economic growth has remained very modest. It is becoming increasingly clear that no matter what the Fed does, there is just not enough demand to drive the required growth. Germany has just published a negative growth number despite offering negative interest rates for some period of time!
So will rate cuts have a positive influence on stock markets and multiples? Only if earnings are sustainable. As always, the winners will be those that can generate earnings regardless of the economic environment that they are operating in. However under current circumstances a special focus on balance sheets and investing in companies with low debt levels may be a way to help reduce long term default risk.
Ultimately, as in everything in life, you get what you pay for!