Are lower rates automatically good for stocks?

Surprising many, the Bangko Sentral ng Pilipinas (BSP) last week said it might cut the benchmark rate of 6.5 percent by as much as 50 basis points this year starting in August. This was after it changed its inflation forecast for 2024 to 3.8 percent from 4 percent previously.

Theoretically speaking, lower rates should be good for the stock market as it should lead to lower funding cost, encouraging more consumers and businesses to spend. This in turn should boost corporate earnings, which is beneficial for share prices.

However, during the past several years, the stock market’s performance six months and 12 months following BSP rate cuts has not always been positive.

In 2012, the stock market performed strongly, with the Philippine Stock Exchange Index (PSEi) closing higher by 13.4 percent and 33.3 percent six months and 12 months following the central bank’s first rate cut in January.

However, in 2016, the PSEi initially posted a sharp correction before rallying after the BSP’s first rate cut in May.

Recall that Rodrigo Duterte began his term as the Philippines’ president that year. His pronouncement he would cut ties with the US hurt investor sentiment, negatively affecting the performance of the bourse. Donald Trump was also elected US president that year, raising worries he would implement protectionist policies that would hurt emerging markets.

Because of the said factors, the PSEi fell by 8.4 percent six months after the BSP’s first rate cut. Nevertheless, 12 months later, the PSEi successfully recovered and was higher by 5.9 percent compared to its May 2016 level.

In 2019, the stock market failed to go up at all despite rate cuts that began in May. The market’s poor performance was due to the worsening US-China trade war, which negatively affected sentiment for emerging markets. The COVID-19 pandemic, which began in early 2020, also downplayed the favorable impact of rate cuts on the economy.

In short, while rate cuts are good, other factors are also important in determining whether the market will go up.

If the BSP pushes through with rate cuts in August, one factor that could hurt the local bourse’s ability to go up in the next six to 12 months is the performance of the US economy and its stock market.

Many economists believe that the US is still at risk of suffering from a hard landing. In fact, this might be the reason why Fed chair Jerome Powell turned more dovish recently.

Powell had said the Fed would slow down the pace at which the central bank reduces its securities holdings from $60 billion to $25 billion a month starting in June. Moreover, for the first time since it began raising rates, Powell said the Fed was prepared to respond to an unexpected weakening in the labor market given the central bank’s dual mandate of stable prices and maximum employment. This might imply that the Fed is starting to worry about the health of the labor market.

There are signs the US labor market is weakening. In April, the unemployment rate rose to 3.9 percent while nonfarm payrolls increased by 175,000. Both numbers were weaker than expected as consensus was expecting the unemployment rate to stay at 3.8 percent while nonfarm payrolls were expected to increase by 240,000.

If the US suffers from a recession, US stocks are at risk of falling sharply. Note that the S&P 500 is currently trading at 20.9X price-to-earnings ratio, significantly above its 10-year historical average of 18.1X.

Moreover, while rate cuts are theoretically good for the market, stocks have historically always declined first following Fed rate cuts. This is due to the Fed’s poor track record of successfully controlling inflation without overtightening.

In the past, the Fed’s tightening cycle always resulted in a recession and bear market. The only time this did not happen was in the 1990s. However, during that time, the spread between the 10-year and the two-year bonds did not turn negative as then chair Alan Greenspan was quick to stop raising rates before the yield curve inverted. By contrast, the yield on the two-year bond has been higher than that of the 10-year bond since July of 2022.

Despite this, the Fed continued to raise rates until July of 2023. It has also kept the Fed funds rate elevated at 5.5 percent up to today, increasing the likelihood that the economy would suffer from a recession and a bear market.

If both will materialize in the US, it will be bad news for local stocks since the Philippines has always suffered from a contagion. As such, even if the BSP cuts rates, investors should closely watch the US economy and the stock market to determine whether local equities will perform well in the short term.