As investing doctrines go, "Don’t Fight the Fed" is a pretty good one. While value investors may grumble about the distorting effect of low interest rates on market fundamentals, the reality is central banks affect asset prices in very immediate and significant ways. When the Federal Open Market Committee meets on July 30 and 31, the main debate between market participants will be whether it cuts rates by 25 or 50 basis points. Here’s what the latest research note from Morgan Stanley MS says on the matter:
“On the size of the cut, our economics and rate strategy teams agree that the Fed is likely to cut 50 basis points. This compares with the consensus, which is leaning towards a 25 basis point cut. In probability terms, the bond market is pricing in a 100% chance of a 25 basis point, but only a 20% chance of a 50 basis point cut. In short, a 50 basis point cut would be a modest surprise to the markets.”
One of the reasons why the analysts at Morgan Stanley believe the cut could be larger than expected is the spread between 10-year Treasury yields and the federal funds rate (i.e., the yield curve) is 35 basis points. Therefore, a 25 basis point cut will not be enough to un-invert the yield curve.
The real question is: how will the market react to the cut? The bank reckons the cut might be, to a certain extent, priced in, and that there are more fundamental problems investors should be thinking about:
“When we made our call for an earnings recession last September, it was out of consensus. In January, when equity markets were down close to 20% and companies started missing forecasts, our earnings recession call became more popular. But now with stocks making new highs, it seems as if investors are either looking through the earnings recession, or have forgotten about it.
So far, the second-quarter earnings season has failed to dispel our concerns that there is more bad fundamental news to come in the second half of the year. If we’re right, the re-acceleration that equity markets are now expecting will fail to materialize, no matter what the Fed does this week. At current prices, we think that translates into a 10% correction for equity markets broadly, which means 20% or more in the crowded growth stocks which have become increasingly expensive.”
In other words, the bank expects there to be a certain degree of selling after the Fed meeting. Why? Historically, rate-cutting cycles are not good for equities, at least not at the start:
“The beginning of a new full-blown rate-cutting cycle is typically not good for stocks, with the last two stocks being September of 2007 and January of 2001. The lesson is that although the Fed can impact asset prices almost immediately with a change in policy stance, they can’t really reverse an actual slowdown immediately. Our advice is to stay defensively orientated in your portfolios until the slowdown gets properly priced again.”
Disclosure: The author owns no stocks mentioned.
Read more here:
- 2 Pieces of Investing Wisdom From Seth Klarman
- Buffett on Using Options as Compensation
- Seth Klarman: Value Investing in a Turbulent EnvironmentÂ
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