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The Big What-If: Federal Reserve Cuts and Implications

Zoe Team

Sep 24, 2019

3 min read

A financial advisor reviewing a plan with two clients at a table

Key Takeaways

Federal Reserve interest rate decisions create market noise, but investors should stay focused on their personal financial goals.
Predicting market reactions to rate cuts is difficult; rely on a robust strategy rather than trying to time the market.
Personal financial health depends on long-term planning, not on reacting to every news cycle about Fed policy changes.

Frequently Asked Questions

Do Fed rate cuts always mean a market crash?

Not necessarily. Market reactions are complex and often already priced in by the time news breaks.

How should I react to Fed news?

Don’t panic. Focus on your long-term portfolio strategy rather than making changes based on temporary news cycles.

Should I adjust my portfolio for rate cuts?

Generally no, unless your individual financial situation or long-term goals have changed significantly.

The potential of Federal Reserve cuts has the market - and finance news - in a frenzy. With seemingly infinite information out there, you’re likely wondering what this means for you and your portfolio. We at Zoe Financial don’t pretend to have a crystal ball, but that doesn’t stop us from attempting to crystallize the present by being data-driven and providing some historical context to today’s environment.

The Trillion Dollar Question: Answered

If the Federal Reserve cuts in July, what can we expect from global asset classes? It is critical to remember that a Fed cut does not operate in a vacuum. We need to see how the global economy holds up while the cuts occur.

Below, we provide two simple scenarios that most closely represent what has occurred in past similar scenarios. The JP Morgan charts depicted look at the average 3-month performance of a broad set of asset classes when the Fed cut and GDP growth accelerated and decelerated over the last 40 years.

Fed Cuts and Growth Accelerates

Not surprisingly, if the Fed cut rates and growth accelerated, Emerging Market (EM) equities outperformed all other asset classes. The recipe of faster global economic growth is a big tailwind for EM equities.

Surprisingly in this scenario, US bonds slightly outperformed U.S equity, although the data incorporates the 1980s in which bond yields were falling from much higher levels.

Fed Cuts and Growth Decelerates

On average, and in this particular scenario, we see that global equities fell while bonds provided strong performance.

U.S. Equity and Its Drivers

The two most important drivers for long term equity returns are 1) Earnings growth and 2) Valuations. Let’s take a look at where we stand on both of these pillars.

Earnings Growth

For 2019, analysts project a low single-digits earnings growth of 2.6%. This is compared to the double-digit earnings growth seen in 2018. Thus, we can’t expect U.S equities to be THE driver by this factor this year, despite it being the stickiest and most reliable driver of equity returns in the long term for similar scenarios.

Valuations

That leaves us with Valuations. The issue with valuations as a driver is that it is not a strong predictor in short periods of time (under a year.) In other words, although markets are not “cheap” right now, they can continue to get more expensive for quite a while!

Especially if the Federal Reserve lowers the cost of capital by cutting interest rates back closer to 0%. As below Seeking Alpha chart shows, there is a negative relationship between interest rates and equity valuation multiples. The lower interest rates are the more investors are willing to pay for a stock’s future earnings and vice versa.

So…What Happens to the US Dollar?

If the Fed cut rates in July and global growth holds up, it could be the beginning of the end of the dollar bull cycle as both relative growth and interest rate differentials are big drivers for the dollar.

Noteworthy: the current dollar valuations are stretched to begin with, particularly when compared to their real effective exchange rate terms historical averages.

Money Chase Yields if Fed Cuts

The JP Morgan chart below is a handy and effective resource for evaluating asset class yields globally. For example, note that Asian HY bonds and local EMD bonds will look even more attractive than before if the Fed cut rates.

The “Aha” Moment

Experience, data-driven research, and well-informed historical background can be helpful tools for contextualizing the current Federal Reserve cuts and potential implications. Having said that, the reality is we don’t know what is going to happen next. The good news is, as below Deutsche Bank chart shows, no one else knows.

The Trillion Dollar Question: Answered

Fed Cuts and Growth Accelerates

Surprisingly in this scenario, US bonds slightly outperformed U.S equity, although the data incorporates the 1980s in which bond yields were falling from much higher levels.

Fed Cuts and Growth Decelerates

On average, and in this particular scenario, we see that global equities fell while bonds provided strong performance.

U.S. Equity and Its Drivers

The two most important drivers for long term equity returns are 1) Earnings growth and 2) Valuations. Let’s take a look at where we stand on both of these pillars.

Earnings Growth

Valuations

So…What Happens to the US Dollar?

Noteworthy: the current dollar valuations are stretched to begin with, particularly when compared to their real effective exchange rate terms historical averages.

Money Chase Yields if Fed Cuts

The “Aha” Moment

Disclosures: Zoe Financial, Inc. ("Zoe Financial") is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Zoe Financial provides investment advisory services and access to independent registered investment advisers through its platform. The information provided by Zoe Financial is for educational and informational purposes only and should not be construed as personalized investment advice or as an offer to buy or sell any security. All investments involve risk, including possible loss of principal. Past performance is not indicative of future results. Clients should consult with their own financial, tax, or legal professionals before making any investment decisions. The material presented by Zoe Financial is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Material presented has been gathered from sources believed to be reliable, however Adviser cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Past performance is no guarantee of future results. Zoe Financial does not provide legal or tax advice, and nothing contained in these materials should be taken as legal or tax advice. SEC Registration does not constitute an endorsement of Zoe Financial by the SEC nor does it indicate that Zoe Financial has attained a particular level of skill or ability. The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned may not be appropriate for all clients. Before making any investment, each investor should carefully consider the risks associated with the investment, as discussed in the applicable offering memorandum, and make a determination based upon their own particular circumstances, that the investment is consistent with their investment objectives and risk tolerance. Lower expenses do not guarantee better investment performance. Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: This page is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

Investment advisory services are provided by Zoe Financial, Inc. (Zoe Financial), an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training. Learn more about Zoe Financial on the SEC’s Investment Adviser Public Disclosure website. Brokerage services are provided by Zoe Securities LLC and Apex Clearing Corporation, members of the Financial Industry Regulatory Authority Inc. (FINRA) and Securities Investor Protection Corporation (SIPC). Learn more about Zoe Securities and Apex on FINRA’s BrokerCheck website.

The information in the visuals above is for illustrative purposes only and does not represent an actual user's account, balance, or return. Zoe Financial does not provide tax or legal advice.

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