Why interest rate cuts aren’t always good news

When central banks cut interest rates, the initial reaction is often positive. Investors, traders, and media outlets typically focus on the immediate benefits—lower borrowing costs and potential a boost to economic activity.

However, while this may generate short-term optimism, it’s important to understand that the broader implications for the stock market may not be as beneficial in the long term.

First, let’s take a step back and understand why markets tend to react positively to interest rate cuts, at least initially. At a basic level, the value of any asset, including stocks, is derived from the present value of its expected future cash flows.

This simple framework relies on two key inputs—the magnitude and timing of the cash flows and the discount rate used to compute their present value. Interest rates directly affect the discount rate used in these calculations.

When interest rates are cut, the direct response in stock valuations is positive because as the discount rate decreases, the present value of future cash flows goes up. This is why rate cuts often lead to stock price increases in the short term.

Theoretically, when rates go down, the opportunity cost of capital goes down, and therefore, stocks become more attractive relative to bonds or other fixed-income securities.

For example, when the US Federal Reserve cut interest rates in September, the yield on the Philippine 10-year bond fell from 6.14 percent to 5.75 percent. This makes investing in stocks more appealing, as they offer a higher return, with an earnings yield of 8 percent based on a trailing Price-to-Earnings ratio of 12.2 times.

But this narrative can be deceptively simplistic. In the real world, a lower discount rate isn’t the only thing that changes when interest rates are cut. Often, these rate cuts are a signal of deeper economic issues that could outweigh the benefits of lower rates.

Let’s start with why central banks cut interest rates in the first place. Generally, it’s a response to economic weakness or sluggish growth. By cutting rates, central banks aim to stimulate borrowing and spending. However, this is a reactive measure rather than a proactive one. A rate cut is often a signal that economic growth is slowing.

For the Philippines, which has a high dependence on consumer-driven sectors and overseas remittances, a rate cut might be a signal that domestic demand is faltering.

If we examine the revenue growth performance of the Philippines Stock Exchange (PSE) Index companies in the first half of each year, a clear slowing trend emerges. The postpandemic median revenue growth, which was 19 percent in 2022, dropped to 11.8 percent in 2023, and further to 6.8 percent this year.

When rates are cut, the expectation is that it will boost economic activity, but it also introduces concerns about why the rate cut is happening in the first place.

In the context of valuation, this raises a critical issue. While lower rates reduce the discount rate in your DCF (discounted cash flow) models and inflate the present value of future cash flows, the expected cash flows themselves could take a hit if the economy is entering a period of slower growth.

Simply put, if the revenue growth and earnings projections of companies are reduced, that benefit from the lower discount rate could be wiped out by a shrinking cash flow base.

Another issue with rate cuts is the risk of inflation. The Philippines, with its history of volatile inflation, is particularly sensitive to changes in interest rates. When rates are lowered, the impact can be inflationary, especially if it leads to a weakening currency. A weaker peso, for instance, raises the cost of imports, leading to higher prices.

Another consequence of sustained low interest rates is that they encourage excessive borrowing. This might seem beneficial initially, as companies take advantage of lower borrowing costs to fund expansion or new projects.

However, the problem arises when companies take on debt beyond their capacity to manage. In an economy where many businesses are already highly leveraged, lower rates could lead to an increase in corporate debt levels growing faster than their ability to generate cash flows.

Over time, this creates a systemic risk where heavily indebted companies are vulnerable to even minor economic shocks. The ratio of total debt-to-total market cap in the PSE over the years has increased from 34.7 percent in 2017 to 50.2 percent by end of 2019. Today, it is estimated at 63.2 percent.

This leads us to another important point—lower interest rates often fuel speculative behavior in equity markets. Investors, seeking higher returns in a low-rate environment, may push stock prices higher, leading to overvaluation. If rate cuts lead to inflation and excessive borrowing, the market will eventually face a painful correction.

While interest rate cuts may boost the stock market in the short term, they also carry significant long-term risks. It’s important to remain cautious and avoid getting caught up in the excitement. Instead, focus on the fundamentals and stay mindful of the long-term risks that could impact the market.

Henry Ong is a Registered Financial Planner of RFP Philippines. To learn more about investment planning, attend the 108th batch of the RFP Program this October 2024. To inquire, e-mail [email protected]