As interest rates start to decline, the potential investment of cash currently being housed in money markets could significantly boost equity market performance, counteracting economic headwinds caused by higher interest rates. However, opinions on this outlook are divided. Here’s a look at both sides of the argument.
THE OPTIMISTS
Analysts who believe that equities are set to benefit from lower interest rates base their assumptions on the fact that equity will provide better returns than money markets. It could be argued that these analysts are also more tolerant of the increased risks that equities pose. Some of their arguments include:
Potential for higher returns
Advocates of this view believe that equities offer attractive returns, particularly in the current economic environment. With the anticipated decline in interest rates, equities may start to yield better returns than money market funds. In addition, the anticipated return from equities is often higher than the yield on money market funds, making equities more appealing to investors who are happy to take on more risk with the prospect of better returns.
Sector-specific opportunities
Certain sectors, such as technology and healthcare, are positioned to grow significantly. These sectors are driven by innovation and demographic trends, which continue to attract investor interest. Companies within these sectors often have higher growth potential, making them attractive targets for investment. The technology sector’s rapid advancement and the healthcare sector’s ongoing innovation provide compelling reasons for investors to shift their funds from money markets to equities.
Historical precedents
Historical trends support the idea that as interest rates fall and monetary policy eases, significant cash reserves will eventually flow into the stock market. Following the 2008 financial crisis, substantial inflows into equities were driven by low interest rates and quantitative easing measures. A similar scenario could unfold if economic conditions stabilise and investor confidence returns.
THE SCEPTICS
On the other side of the debate, analysts who believe the move to equities is overstated are not convinced that the risk-reward trade-off is at a point where it will draw investments away from money markets into equities. In addition, many believe that economies remain vulnerable because inflation and geopolitical risks continue to drive market volatility. Their arguments include:
High-yielding money market funds
Currently, money market funds offer high yields, providing attractive returns on a risk-adjusted basis. This attractiveness could deter investors from moving their funds into the more volatile equity markets. The current yields on money market funds are competitive with those of some low-risk equities, making them a safer option for risk-averse investors.
Economic and geopolitical uncertainty
The global economic landscape is fraught with risk, including a global economic slowdown, inflationary pressures, and geopolitical tensions, such as the ongoing conflict in Ukraine and strained US-China relations. These are all contributing to market volatility and may encourage investors to maintain their cash positions as a safer alternative.
Corporate profit pressures
Corporate profits are under pressure due to rising costs and slowing sales growth. Reports indicate that United States (US) corporate profit margins are expected to contract, which could negatively impact stock values. Concerns about a slowdown in US economic activity, reduced US consumer demand, and the resulting effects on company earnings could further deter investors from allocating substantial funds to equities in the near term. If corporate profits decline, stock prices may follow suit, making equities less attractive to investors.
A lack of breadth in market rallies
The recent resilience in global and US share prices has been driven by a narrow group of large-cap stocks. The broader market, as measured by equal-weighted indices, has not shown the same resilience. This lack of breadth suggests that the market rally may not be as robust as headline indices imply, raising questions about the sustainability of any potential inflows.
Interest rate sensitivity
The relationship between interest rates and equity performance is complex. Typically, lower interest rates benefit growth stocks, while higher rates favour value stocks. With current high interest rates, value stocks might see more inflows, but the overall equity market will remain sensitive to interest rate fluctuations and central bank policies. For example, if interest rates remain high, value stocks may perform better, but growth stocks may struggle, affecting overall market performance.
While there is potential for substantial inflows into equity markets, driven by large cash reserves (although it is important to note that the current rolling value of these cash reserves is not above long-term averages) and attractive sectors, barriers remain. High yields on money market funds, economic and geopolitical uncertainties, and corporate profit pressures all present challenges to the influx of capital to equity markets.
GLOBAL MARKET DYNAMICS AMID ECONOMIC DATA AND RATE-CUT SPECULATIONS
Soft data reigns in US yields
The yield on the US 10-year Treasury note declined to 4.35% on Wednesday, down from a recent high of 4.46%. This drop followed economic data that bolstered expectations for a US Federal Reserve (Fed) rate cut in the nearer term. The Institute for Supply Management (ISM) reported that US services sector activity experienced its steepest decline in four years in June, a stark contrast to the anticipated expansion. Further, the ADP report indicated fewer private sector jobs were added than forecasted, and continuing unemployment claims increased for the ninth consecutive week, reaching their highest level since 2021. Despite positive surprises in job openings and job cuts data earlier this week, market consensus is now tilting towards the Fed implementing the first of two 25 basis point rate cuts for this year in September.
In the United Kingdom (UK), the 10-year Gilt yield was around 4.18% on Thursday, having dipped from 4.28% earlier in the week. This movement coincided with parliamentary elections across the UK, where this morning it was announced that Keir Starmer’s centre-left Labour Party has unseated Prime Minister Rishi Sunak’s Conservative Party with a historic landslide win, as predicted by various polls. Labour has taken the approach of a “pro-business and pro-worker” agenda with a new industrial strategy, steering away from talks of tax hikes or a tighter fiscal belt, but undoubtedly the biggest driver of the result was public antipathy towards the incumbent Conservative government. The Tories saw their right-wing base split by Farage’s Reform Party but ultimately paid the price for dysfunction within the party and the UK’s economic malaise.
Brent crude settles near two-month highs
Brent crude futures stabilised around $86.80/barrel, near a two-month high. This was supported by a substantial drop in US inventories, with the Energy Information Agency reporting a 12.2-million-barrel decrease, far exceeding expectations. Additionally, weaker US economic data has raised hopes for a rate cut in September, boosting confidence in US and global economic growth and energy demand.
Gold prices approached $2,360/ounce on Thursday, nearing a four-week high. The recent economic data increased expectations for a Fed rate cut in September. Additionally, safe-haven demand for gold rose amid escalating tensions in the Middle East following a senior Hezbollah commander’s death, leading to retaliatory actions near the border.
US stocks revel ahead of Independence Day
US stocks mostly closed higher on Wednesday, ahead of the US’s 4th of July (Independence Day) public holiday. The S&P 500 rose 0.5% to a record 5,537, and the Nasdaq 100 gained 0.8% to a record 20,187, while the Dow slightly decreased. Weak US economic data bolstered investor confidence that the Fed might start its rate-cutting cycle soon. Electric vehicle manufacturer Tesla continued its rally, gaining 23% since the beginning of the week.
The FTSE 100 increased by more than 0.5% on Thursday, driven by medical technology company Smith & Nephew, which surged 6.7% after investment firm Cevian Capital acquired a 5% stake. In Europe, Germany’s DAX rose by 0.4% to 18,450, adding to a 1.2% gain the previous day.
In Japan, the Nikkei 225 Index jumped 0.82% to 40,914, and the Topix Index rallied 0.92% to 2,899. Japanese shares hit new all-time closing highs, supported by a weakening yen, which enhances the profit outlook for export-heavy industries.
Euro soars to three-week high
The US Dollar Index held around 105.3 on Thursday, weighed down by weak US economic data, which increased the likelihood of Fed rate cuts as soon as September. Investors are now focused on today’s non-farm payrolls report for more labour-market insights.
The euro rose to approximately $1.08/€, its highest level in three weeks, following the European Central Bank’s expression of concerns over increasing inflation trends and making further rate cuts. While the timing of these cuts remains uncertain, investors are speculating on the likelihood of further monetary easing.
The pound remained steady at $1.27/£, near its three-week high, as the UK election unfolded. The Labour Party’s victory is expected to boost the pound in the short term, after which the focus will shift to expectations for a Bank of England rate cut in August.
Key Indicators:
GBP/USD: 1.2757
GBP/EUR: 1.1803
GOLD: $2,365.52
BRENT CRUDE: $87.09
Sources: Reuters/Refinitiv, Bloomberg, BCα Research, Seeking Alpha, Morningstar Market Watch, Goldman Sachs Asset Management and Trading Economics.
Written by Citadel Global Director, Bianca Botes.
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