Interest rate cuts with no recession is positive for US stock markets
The S&P 500 rose by 5.6% over the third quarter, reaching new highs. While the second quarter’s leadership came from the technology sector, this quarter saw the Real Estate, Utilities and sectors register strong returns. As the US shifts into a period where interest rates are declining, Real Estate and Utilities companies, usually operating with higher levels of debt, will likely benefit from lower financing costs. In particular, those Real Estate and Utilities companies which will help to provide infrastructure to increased spending by technology companies, such as Data Centre company Equinix (+16% for the quarter) and Utilities company Nextera (+21% for the quarter), were market leaders.
While the announcement by the US Federal Reserve of a 50bp cut in September was not too much of a surprise, what changed over the quarter was the market’s view as to where short term interest rates will “finish” or the “terminal rate”. One can get the market view by looking at the “Fed Funds Rate implied by the 24 month Futures Price” – essentially an estimate as to what cash rates will be two years from now. According to data provided by Apollo, for much of the last two years, the market believed that the “terminal rate” would be somewhere between 3.5% and 4.5%. In recent months, the terminal rate has dropped to closer to 2.5%, with 10-year bond yields also falling to 52-week lows of 3.7%. These falling rates were also seen to be beneficial for the housing market and for the US consumer, who may benefit from a decline in mortgage rates. US Homebuilder Lennar rose 24% over the quarter, while US home improvement company Home Depot rose 16%. This strength was also seen across other large Consumer Cyclical companies, in particular such as Starbucks (+25%) and Nike (+19%) which also announced surprise changes in their CEOs.
In general, research by the well-respected independent research group Ned Davis Research has shown that stocks perform well in the 12 months following the first rate cut. Since 1974, stocks have been positive 80% of the time, with an average return of 15%. For the moment, there is no sign of a recession in the United States. Since 1980, five of the 10 best years for the S&P 500 happened when the Fed was cutting rates without a recession (1985, 1989, 1995, 1998, 2019). The Fed has cut rates 12 times when the S&P 500 was within 1% of its all-time high. The market was higher one year later all 12 times (with a median return of 15%).
The good news over the quarter was compounded by China’s central bank on Friday lowering interest rates and injecting liquidity into the banking system. Hedge Fund manager David Tepper announced that he would “buy everything” in China, while the Shanghai CSI 300, the stock market of local Chinese shares, hit a 52-week high of 3,700 on the 27th September, only two weeks after hitting a 52 week low of 3,155! The strength in the Chinese stock market was mirrored by strength in those shares with perceived strong exposure to China, such as the mining company Rio Tinto, up 13% over the month, and Luxury manufacturers such as Hermes, which rose 18% in 18 days.
Source: Bespoke Investment Group
Lessons from Alexander Brown on dealing with Geopolitical instability
Many clients remain concerned about Geopolitical risks globally. The “flash crash” in early August helped to contribute to this sense of unease. In four trading days, the S&P 500 dropped by 6% (with a 9.7% total decline over 20 days). There have been 26 times since March 2009 where the S&P had a decline of 5% or more, but it was only the second time since the Global Financial Crisis that the VIX, or measure of stock market volatility, rose above 64 (with the other time being during the COVID-19 crisis). In the end, the decline was attributed primarily to an unwinding of $16billion of contracts betting on a weaker yen, with the selloff proving temporary. Nevertheless, many clients continue to believe that sharp declines could occur in the near future, with the numerous geopolitical flashpoints around the world (Taiwan, Ukraine, the Middle East and US Presidential Elections) serving as potential catalysts.
Although it may feel that geopolitical uncertainty today is as bad as it has ever been, there have, of course, been many times in the past where financial markets have been disrupted by conflict. In 1800, linen merchant Alexander Brown left Ireland and sailed for Baltimore, along with his four sons, with the aim of benefiting from the increased trade in linen between the newly-formed United States and Britain. What started out in linen expanded into numerous commodities and one son, William, was dispatched to Liverpool to administer the business from the English side. Although the business was successful, in 1807 Thomas Jefferson passed the Embargo Act, banning American Trade with both countries. The company, which would eventually be called Brown Brothers, was able to “muddle through”, but in 1812 Alexander grossly miscalculated the political environment. He believed that it would be “impossible” for the United States to have “any serious intention of going to war with England”. On 18th June, 1812, the United States declared war on Britain. The war would continue until 1815.
While Alexander was gravely wrong in his expectations, his management of the company during the war proved to be very successful. What typified the management was caution, rather than taking too much risk: “the primary objective is safety”. Thus the ship that had been recently commissioned, the Armata, an investment that had consumed considerable capital, was relocated away from the North Atlantic shipping lanes to the neutral port of Lisbon, Portugal. While this move would put the ship out of commission, it would also ensure that the ship was not seized. As a biographer wrote, “if there was incidental profit to be made, (Brown) would make it, but his first priority was to preserve and conserve”. This caution-first approach allowed Brown to survive and establish a business that remains in existence today (Brown Brothers Harriman), acting as custodian for $3.3trillion of assets.
While Geopolitical conflict can upend financial markets in the short term, great companies can navigate seemingly insurmountable challenges: Brown started off trading goods between the United States and England – war between the two countries would have been as damaging for the business as a Chinese invasion of Taiwan would be for the Semiconductor industry. Nevertheless, the business continued and thrived despite the conflict.
A second lesson is one that stands at odds with the well versed “buy the dip” mentality espoused by many market participants today, where every correction is seen as an opportunity to increase one’s risk. Where there are sell offs, such as the one witnessed in early August, we believe that there is nothing wrong with following Alexander Brown’s lead and remaining cautious, trying to aim for steady gains rather than aggressive action to benefit from opportunities caused by a singular geopolitical event.
Source: Defence of Fort McHenry, 1814
KDT on Wall Street
Our New York office has recently moved to 14 Wall Street, opposite the New York Stock Exchange – below is a photo of Colin, Roger, Peter and me standing outside the stock exchange and our new offices!