Remember Why We Cut Interest Rates!

Easing interest rates is a tool central banks use to combat a weak economic outlook. While it can be positive for equities, the underlying weak economic outlook is not bullish for equities!

This week’s Headline Risk comes courtesy of the common misconception that dovish central bank policy is always bullish for equity markets.

While anticipation of lower interest rates may boost equity markets, one must remember that the catalysts for lower interest rates usually is evidence of a weakening economic outlook.

Here are some recent examples of why dovish policy is not necessarily good for equities:

South Korea  

On July 17, 2019, the Bank of Korea “surprised” investors with a rate cut. This central bank development wasn’t a surprise to anyone who is data-dependent because South Korea’s growth has been slowing for over a year and the economy has been in a Winter Fundamental Gravity for two of the last three quarters. Since the rate cut, the Kospi (South Korea’s equity market index and the largest stock index by trading volume int eh world) has fallen 6.2% and has now corrected 13.4% from its April 7, 2019 peak. This financial market development isn’t a surprise given that during Wintertime, South Korean equities average a three-month loss of 5.5%, experienced a maximum drawdown of 15.2% and post negative three-month returns 65% of the time.

India

Two weeks ago, the Central Bank of India made their fourth rate cut of the year. However, this time around they cut by 35 basis points after following a cadence of a 25-basis point cut every other month for the first six months of the year. The Central Bank of India is ramping up its policy response to combat the fact that India’s economic growth has been slowing for five straight quarters and that it's experienced a Winter Fundamental Gravity in three of the last four quarters.

Against a Winter Fundamental Gravity backdrop, the S&P CNX Nifty Index (India’s equity market proxy) typically averages three-month returns of -4.8%, peak-to-trough drawdowns of 10.9% and positive returns just 43% of the time.

Despite an uber-dovish central bank delivering four rate cuts in seven months, the Nifty Index is down 3.1% since the latest rate cut was announced and has now declined 10.5% since peaking on June 3.

Thailand

On Aug. 7, the Bank of Thailand also “surprised” investors with its first rate cut in more than four years. Here again, economic growth has been slowing in Thailand since Q4 2017, nearly two full years! More importantly, the Thai economy has been mired in a Winter FG for the last two consecutive quarters, and as you may guess, Thai equities don’t perform very well.

In Winter Thai equities typically deliver 4.91% losses on a three-month basis, experience 16.7% a peak to trough drawdown and deliver negative returns 64% of the time. So, is it any wonder that the MSCI Thailand Index is down 2.2% since the cut and in correction mode with an 8.4% decline since its July 1 peak?

Foreign and Domestic
For those Americans who believe these rate cut-induced equity sell-offs are a non-U.S. problem, think again. The S&P 500 has corrected 4.8% since the Fed cut rates on July 31 and it’s now down 5.2% since printing a new all-time high on July 26.

The Bottom Line

The Headline Risk bottom line is that central bankers don’t cry dovish and cut interest rates because their economy is in awesome shape. They cut rates, buy assets and do “whatever it takes” because growth and inflation prospects are weak or turning negative.

While everyone is clamoring for more easing juice, they forget why we cut interest rates and how this experiment in prolonged low or zero interest rates has played out previously. After 20 years of zero rates and printing more than 100% of GDP, Japan’s stock market is roughly where it peaked in 2000, and 47% below its 1989 high. The European Central Bank thought Quantitative Easing worked, so it copied Japan, and the Eurozone stock market remains 38% below its 2000 peak.

Let the prevailing Fundamental Gravity be the foundation of your decision making, and your portfolio will not suffer the same: “I’ve fallen, and I can’t get up” fate as Japanese and Eurozone stock markets.

Interest rate cuts have a positive affect on equities, but they are implied to address overall weakness. It should never be the catalyst of a bullish outlook.

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