Markets Brief: Are Fed Rate Cuts Always Positive for Stocks?

The Morningstar US Market Index rose 0.4% following the delayed release of the PCE Price Index, the Federal Reserve’s preferred measure of inflation. This last significant release before the Federal Open Market Committee meets this week showed that inflation in September was in line with expectations. The probability of a December rate cut remains at 86%, according to CME FedWatch. Less well reported was the weakness in consumer spending, which was flat in real terms and has negatively impacted assessments of economic growth in the third quarter, according to the Federal Reserve Bank of Atlanta GDPNow estimate.

Do Interest Rates Boost Stock Prices?

Given the optimism with which investors have greeted this inflation data, it is worth considering the link between interest rates and asset prices. It is assumed that lower rates will be positive for equities, as it reduces the returns required to justify investment in riskier assets. It also provides a boost to consumption and investment by lowering the costs to indebted companies and consumers. However, this is overly simplistic, because monetary policy is a blunt instrument that is not well suited to fine-tuning economic growth.

Successful investors must therefore consider a range of possible outcomes, and look beyond the immediate reaction in asset prices to the longer-term potential effects. Interest rates that are too low in the short term can raise longer term inflation and interest rate expectations, leading to lower currency and bond prices.

This was illustrated by a 0.5% decline in the US dollar over the week, together with a 0.1% rise in 10-year Treasury bond yields. This prompted bifurcation in bond markets, with both the Morningstar US Treasury Bond Index down 0.6% and the US Core Bond Index 0.5% lower, while the US High-Yield Bond Index rose 0.2%.

These price movements are a reminder that the returns of high-yield bonds tend to be positively correlated with those of equities and often negatively correlated with US Treasuries. While this can boost returns when investors are optimistic, these securities are less likely to provide diversification to a portfolio if that sentiment darkens.

How to Build Sustainable Income

Diversification is especially important when investing for income, as volatility in asset prices can harm a portfolio and the income it is generating. Morningstar has just published its State of Retirement Income report to help investors and advisors identify the sustainable withdrawal rate for their portfolios. To find out more about building a sustainable income portfolio check out this article by Nick Stanhope, a senior portfolio manager for Morningstar Wealth.

The decline in the dollar over the past week benefited the Morningstar Developed Markets ex-US Index, which rose 0.6% and Morningstar Emerging Markets, which was 1.2% higher. The Morningstar Korea Index was especially strong, rising up 4.6%, as investors remain enthusiastic about technology companies outside the US.

Is Netflix Deal the New AOL Time Warner?

Within US markets Netflix NFLX stock fell 6.8% over the week on news of its planned purchase of Warner Bros. The deal requires regulatory approval, which is highly uncertain. Morningstar Analyst Matthew Dolgin assigns a 50% chance of success. Several commentators have likened this transaction to the disastrous takeover of Time Warner by AOL at the peak of the dot-com bubble. While there are undoubtedly similarities, the ease with which this analysis leads us to a broader conclusion of the future direction of the market overall is a reminder of how dangerous narratives can be when we are making investment decisions.

Utilities Hit By Data Center Uncertainty

The decline in Netflix muted the rise in the US communication services sector, which nevertheless gained 0.8% as index heavyweights Meta META and Alphabet GOOGL rose. In contrast, US utilities was the worst performing sector last week, as investors appeared to question the scale of the opportunities provided by the construction of data centers. However, despite this decline, utilities stocks continue to trade above Morningstar’s estimates of their fair values, providing a seasonal reminder that simply because assets are on sale does not mean they are ‘cheap’.

The Line Between Investing and Gambling

While the outcome of the interest rate decision on Wednesday is likely already in the price of assets, the decision-making process is expected to be contentious, and no doubt market commentators will be focused on the longer-term direction of interest rates. This may produce some volatility in asset prices, exacerbated by the lack of market participants at this time of year. It is therefore unusually important to remain focused on the long term rather reacting to every move in prices. Morningstar’s Danny Noonan highlights the dangers of focusing on price movements, and the confusion between gambling and investing, in his latest Market Minute.