Rate cut delays could bring share price falls

The standard narrative for most of the past quarter is that the inflation shock has already worked its way through the system, enough to bring on multiple rate cuts from the Federal Reserve, European Central Bank (ECB) and Bank of England (BoE) this year.

That expectation, helped along by positive noises from the US Fed, was enough to prompt a rally that saw the S&P 500 rise by 11.7 per cent in the fourth quarter. The Euro Stoxx rose 7 per cent, while the FTSE All-Share was up by a more sedate 3.4 per cent over the same period. The market expectation is for up to six cuts from the Fed and ECB this year, starting as early as March, with four to come from the BoE. 

"The most important discussion in the market as the new year has started is not if, but when and how fast G10 central banks will start to cut policy rates," said Bank of America strategists last week. Expectations have already shifted since the end of 2023, however. That has been driven by data showing headline inflation rates – while still far below their peaks – ticked up again in the US, UK and Europe in December.

Deutsche Bank analysts pointed to the increasing uncertainty surrounding a March cut in the US, which has gone from "fully priced in" in December to a current likelihood of 43 per cent, as per futures markets. Bank of America said sticky inflation and tight labour markets would reduce the number of rate cuts this year. They are forecasting four Fed cuts, three for the ECB and two for the BoE. 

Global equities would be hit in the event of persistent delays to these plans. Deutsche Bank analysts said: "With the good news being priced in, and financial conditions now at accommodative levels, it may be difficult to maintain this optimism for long," they said this week. "Equity gains over the last year have been powered by a select group of stocks, with the 'Magnificent Seven' [tech stocks] rising by 106.6 per cent last year... those equity gains could prove vulnerable to a change in sentiment towards that group." 

But the impact of delayed rate cuts would be seen across equity sectors, with those that did particularly well in the fourth quarter of last year, such as emerging markets and biotechnology shares, the most vulnerable. Still, long-term growth in artificial intelligence (AI) and related industries are likely to insulate those companies that did the best last year, such as Nvidia (US:NVDA). 

There are still plenty who back the rate-cut story. However, Anne Walsh, chief investment officer at Guggenheim Partners Investment Management, said tech stocks may become more volatile even as rates come down.  

"The markets tend to overprice [tech stocks] in the short run and underprice them in the long run," she said in an interview with Yahoo Finance at Davos. "I tend to think of it in the long run as being a really good story to tell, but that doesn't mean there won't be some volatility inbetween." Walsh predicted rate cuts would happen because the US economy would have a harder landing than widely forecast, an outcome that would also knock equities.

Finding a balance

The relationship between the strength of the global economy and the number of rate cuts to be made by central banks in 2024 is unclear. Fewer than expected rate cuts could emerge as a result of sticky inflation, stronger-than-expected economic growth, or both. Alternatively, a recession could mean policymakers slash interest rates in a bid to stimulate the economy. There is also a third option: economic growth remains relatively resilient, at the same time as falling inflation allows central bankers to loosen monetary policy.

Recent data has emboldened commentators who think price growth is still embedded. Economist and former Pimco chief executive Mohamed El-Erian told the recent UBS Global Wealth Management conference that the market is underpricing the impact of service sector inflation. The yield on 10-year Treasuries could finish the year at 4.5 per cent, rather than the 3.5 per cent that the market is forecasting, El-Erian said.  

It should be noted that El-Erian is on the optimistic side of the economic growth spectrum, and forecasts US growth of 1-2 per cent this year. Some analysts think the figure could fall as low as 0.5 per cent.

The debt impact

It is a hard and fast rule that big changes are felt the most at the margins. Clearly, a higher-for-longer interest rate policy would spell real trouble for highly leveraged companies that are now refinancing at markedly higher rates.

Ratings service Moody’s thinks that $204bn (£161bn) of debt needs to be refinanced this year, rising to $698bn by 2028. "We expect further deterioration in corporate fundamentals as businesses continue to adjust to a higher-for-longer interest rate and inflation environment," said Christopher Sheldon and Rory O'Farrell at private equity group KKR. They also predicted fewer cuts in the US, with these only starting in the second half, and therefore do not see a big shift in companies' fortunes. "These cuts will not change the higher-for-longer interest rate environment," they said, adding that companies had largely been proactive in refinancing debt.

Predators such as KKR have been active in buying out public companies in recent months, showing there is plenty of value even with rates and broader macroeconomic conditions pressuring earnings. This points to a hold-the-course strategy for equity investors, and further buying opportunities could emerge if rate cut delays bring shares back down to earth.