Central banks and the outlook for equity markets

The cost of borrowing money is a major driver of stock market returns. Generally, equities have an inverse relationship with interest rates. When rates are rising it becomes a headwind for equities and when they fall it becomes a tailwind.

When a central bank changes interest rates, it affects both the economy and stock markets. If the cost of debt rises, this often leads to companies reining in investment in their business, which has a direct impact on future growth prospects.

It also impacts the way analysts value companies, specifically it changes the “discount rate” on future cashflows that they use in their models. This reduces company valuations when interest rates are rising and vice versa. In the UK, rising rates have a significant impact on households because of the relatively short-term mortgage market compared with other countries.

As the Bank of England raises interest rates, homeowners that need to remortgage will see their monthly payments rise significantly. This reduces household disposable income and, as the UK consumer is the main driver of economic growth, it can lead to a slowdown in gross domestic product (GDP) growth – or even a recession.

The biggest differences between property markets in the US and the UK is the length that a mortgage can be fixed at a specific interest rate. Across the Atlantic, most borrowers fix their mortgage rate for the entire term of the borrowing – usually 30 years.

Generally, Americans will only need to remortgage at a higher rate should they decide to move home. In the UK, borrowers must refinance typically every two or five years across a term of 25 years. So, the steep rise in interest rates has not impacted US households as much as it has in the UK.

Employment key to market optimism

Right now, interest rates are sitting at multi-decade highs in most Western economies – yet the main US indices are continuing to hit new record highs, which may seem counter-intuitive based on the above. The reason for this is that equity markets are forward looking – and major central banks are expected to start to reduce interest rates in the second half of the year. However, despite the rise in rates, there has been no major rise in unemployment.

When people fear there is a risk of losing their jobs, they start to cut back on their spending. Despite the deteriorating economic outlook, unemployment rates have remained very low. Price rises have supported company earnings, despite falling volumes. It has also been difficult in the post-pandemic period to find – and keep – suitable workers. This has made companies more willing to keep hold of their staff and take a short-term hit.

The relative strength of economies as this interest rate cycle peaked has coupled with the prospect of interest rate cuts to keep equity markets buoyant. There had been concerns that a surprise uptick in US inflation in the early months of 2024 may result in the Federal Reserve becoming more cautious and rowing back on its dovish tone. However, markets were reassured by the central bank’s comments following its policy-setting meeting in March.

Of particular importance were the “dot plots” the Fed releases every three months. This chart revealed the interest rate expectations of each member of the rate-setting Federal Open Markets Committee (FOMC). It allows investors to track how the individual members project future economic activity and their views on future official interest rates.

Despite the higher-than-expected inflation readings, the dot plots indicated that FOMC members continue to expect three interest rate cuts in the second half of this year as at March of this year. This has helped support equity markets and risk appetite.

However, there must be some caution about the US rate outlook, as the views of FOMC voting members are now diverging, given the continued strengthening of the US economy. Much will depend on the employment and inflation data from here.

The unemployment rate is a key measure and a potential move above 4.0% would provide enough evidence for the Fed to cut rates as planned mid-year. However, hawks on the FOMC such as Christopher Waller and Raphael Bostic, are not in a hurry to cut rates. If we see a reversal of the labour market loosening that we saw in February, it is possible that they may win the argument to hold off reducing rates until later in the year.

Comments from Fed Chair Jerome Powell in the press conference following the meeting also highlighted a greater focus on unemployment, as it appears that the Fed’s comfort levels have moved now to a trajectory that the balance of risks has shifted more to weaker growth prospects rather than sticky inflation levels. Clearly, employment numbers will be critical to views on rate cuts for the next 12 months.

The ECB to move first on rates?

The Bank of England has also seen a much greater alignment of views across the membership of its rate-setting Monetary Policy Committee (MPC) to keep rates on hold, but recent comments from Governor Andrew Bailey were seen to be more dovish – paving the way for rate cuts starting around the middle of the year. Gilt yields fell on the news and UK equities received a boost, particularly the FTSE 100, which rallied as sterling fell.

Comments from European Central Bank (ECB) members also reiterated the path for rate cuts in mid-2024. The ECB seems more certain to cut rates at their June meeting based on comments from Governing Council members after their March meeting.

Of particular interest was a recent move by the Bank of Japan (BoJ), which marked a historic shift in the country’s monetary policy. Japan’s central bank ended eight years of negative interest rates, in an overhaul of one of the world’s most aggressive monetary easing programmes that sought to encourage bank lending and spur demand. In its first interest rate hike in 17 years, the BoJ said it was lifting its short-term policy rate from -0.1% to “between zero and 0.1%”.

The outcomes of the annual wage negotiations across the country, which were very much at the high end of expectations, were the final pieces falling into place for the BoJ to actually move official rates. Fears that the currency would rally were overdone as the expectations of a move were already high and there was more of a “buy the rumour, sell the fact” behaviour post the announcement, to the point that the yen weakened against the USD. However, the central bank said it will maintain accommodative monetary conditions.

When looking at the expectations currently priced into the market for the key central banks as at the end of March, there are three 25 basis point (bp) rate
cuts for the US and UK and three-and-ahalf 25bp rate cuts for the ECB in 2024.

This appears to reflect a more realistic expectation that is in line with central bank guidance and current economic conditions, rather the over-optimistic view that markets had for most of last year. However, even though there seems to be alignment on the potential timing of first cuts from the three key central banks around the middle of this year, this remains subject to economic data releases during the coming months.

It is also important to note that comments from key central bank officials after the various policy-setting meetings are starting to diverge across the regions. There are definitely reasons for optimism about the trajectory of borrowing costs this year, but there is also still plenty of scope for disappointment if expectations become too extreme.