Fed easing can give equity markets a boost, but it won’t keep them aloft
- The expectation of a rate cut has given US stocks a lift this month, but monetary easing by itself won’t outweigh the more important indicators of economic health, like earnings growth, particularly amid the current political and trade uncertainties
US equity markets are on track to post very strong gains over the month of June, a steep contrast to their performance in May, which was the worst since 2010. The swing can largely be attributed to the “Powell Put”.
This is a reference to both the chair of the US Federal Reserve, Jerome Powell, and a position used in the options market, the put, which gives the holder of that option the right to sell should the underlying price of the asset fall too far. In the context of Powell, the put is some notional point at which the central bank would step in to cut rates and extend further stimulus to the economy, and more than likely keep equity markets aloft.
But can the Fed, and central banks more broadly, really lift equities higher? The easing of monetary policy can create a floor to equity markets, but the drag from trade and political uncertainty will also create a ceiling to market performance.
This ceiling should be considered in the context of market valuation, and a US market which is trading above its long-term average on a price-to-earnings multiple.
Year to date, the largest contributor to US equity performance has been a re-rating of markets. This simply means that investors are willing to pay more for stocks and for the expected earnings of the associated companies. The result is that valuation multiples such as the price-to-earnings ratio have moved higher, despite the challenging investment outlook.
This is where the Fed comes in. As central banks cut interest rates and lower the yield on risk-free assets such as cash and government bonds, equities start to look relatively more attractive and valuation multiples move higher. History shows us that this relationship of “lower rates, higher markets” can hold. When the Fed embarked on easing cycles in the 1990s, equity markets rallied. However, in the easing cycles of 2001 or 2008, there were periods where equities fell, along with interest rates.