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S&P looks at what's at stake for the market as Bernanke & Co. prepare to kick off their widely anticipated Sept. 18 policy meeting
From Standard & Poor's Equity ResearchInvestors are walking on eggshells as they await the Sept. 18 decision by Federal Reserve policymakers. Will Ben Bernanke & Co. leave the target Fed funds rate at 5.25%, lower it by 25 basis points, or go even further by cutting it 50 basis points (one-half of 1%)? We believe the Fed will take the middle ground and cut by 25 basis points, likely doing the same thing at its Oct. 30-31 meeting and again at the Dec. 11 or Jan. 29-30, 2008, FOMC meetings. We believe that most Fed watchers are also eyeing a quarter-point cut on Sept. 18 and that this likely event has largely been built into U.S. equity prices.
Since the Aug. 15 closing low of 1406 for the Standard & Poor's 500-stock index, two days before the Fed's half-point cut in the discount rate, all of S&P's U.S. equity market indexes, along with the 10 sectors in the S&P 500, have advanced from 3.5% to 10.5%, recovering much of what was lost in the July 19-Aug. 15 pullback of 9.4% for the S&P 500. All indexes remain below their July 19 highs, however.
Sector leadership has indicated that a decidedly defensive tone has been adopted by investors, as the Consumer Staples, Telecom Services, and Health Care sectors have led on a relative basis, while Consumer Discretionary, Financials, and Materials have been hit the hardest. S&P's Equity Strategy Group continues to recommend the Energy and Health Care sectors.
% Changes in Sectors and Benchmark Indexes During Recent Decline (7/19-9/14)
S&P Sectors & Benchmarks
S&P 500/Citigroup Growth
S&P 500/Citigroup Value
S&P MidCap 400
S&P SmallCap 600
Source: Standard & Poor's Equity Research
We believe the Fed will continue to lower rates over the next four months primarily to make sure the U.S. economy stays out of recession—and also to push the 1-year Treasury-bill rate (used to set adjustable-rate mortgages) as low as possible—and thereby make the upcoming mortgage-rate resets translate into as little economic upheaval as possible. The ultimate 4.50% Fed funds rate that we anticipate will still not be stimulative, in our opinion, as a neutral Fed funds rate is usually 2% above the core CPI, which is now at 2.2%.
Since we believe the equity markets have risen in anticipation of the Sept. 18 cut in interest rates, a bit of relief selling in an attempt to take profits could be in order shortly after the event (remember the old Wall Street saying "buy on rumor, sell on fact"). Should the Fed choose to leave rates unchanged, which we think is a growing, though still remote, possibility, the market may react negatively as skeptics voice their displeasure with the Fed and accuse it of being asleep at the wheel. Yet still, the Fed may choose to leave rates alone as it awaits more economic data, since the September employment report is seen as rebounding from the dismal August figure, and rising oil and gold prices, as well as a falling U.S. dollar, each hint that inflation remains close to the surface and should not be stoked by aggressive easings.
A rate cut of one-half of a point, however, which anecdotally looks increasingly less likely to us, may encourage investors to think the Fed is trying to make up for lost time and get well ahead of the curve. As a result, equity prices may advance on the news.
Credit Crunch May Persist
We don't think investors will take the negative viewpoint that maybe the Fed thinks things are worse than the rest of us do. Should either a one-quarter or one-half point cut materialize, we caution investors from getting too optimistic that the worst of this credit crunch is behind us and that history will repeat itself and force equity prices higher by the 12.3% typically seen in the six months following the first interest-rate decrease. We remind investors that in 4 of the 11 times since 1945 that the Fed has cut short-term rates, the S&P 500 fell in the following six months despite the initial rate cut. In fact, six months subsequent to the first cut in 1990, the S&P 500 was lower by nearly 14%.
This is of particular interest, in our view, since S&P's chief economist, David Wyss, believes the current financial crisis may resemble 1990-91's savings and loan crisis and junk-bond meltdown. What's more, S&P Economics now sees a 40% risk of a U.S. recession—up from the prior 33% estimate—and reduced its projected real GDP growth forecast for 2008, to 2% from 2.7%. We are concerned that short-term capital markets remain frozen and the commercial paper market remains tight. Further, future projections for corporate earnings-per-share growth may come under increased scrutiny, particularly as we head into the fourth quarter. As a result our yearend S&P 500 target remains at 1510.
So there you have it. We think a rate cut is likely for Sept. 18, with more on the way, but suggest investors remain vigilant as stumbling blocks to economic growth and share price advances remain.