Citigroup Global Markets | Equity Research

Fed Cut Strategy

Our economists now expect the Fed to lower rates on, or even before, the next FOMC meeting on September 18th. We take a look at the impact of US rate cuts on global equity markets. We suggest that the current situation is more like 1998 (when Fed action did turn equity markets) than 2001 (when it did not).

We Now Expect US Rate Cuts

We now expect the Fed to cut at the next FOMC meeting on September 18

Our change in view reflects the rapid tightening of financial conditions experienced over recent weeks. This is occurring against a fundamental backdrop of moderating US growth and gradually improving inflation prospects. Our economists are not panicking, but do believe that the disruption in the US mortgage and money markets have introduced meaningful downside risks for the US economy. We also expect current market uncertainty to keep the ECB, Bank Of Japan and Bank Of England on hold through to the end of the year. We had been previously been expecting them all to hike.

The 75bp reduction that we now expect looks more like the rate cuts of 1995-96 or 1998 than the end-cycle reductions seen in 1989-1992 or 2001-03. This is consistent with our economists? view that, although US demand growth will undoubtedly slow, it is still too early to call the end of this economic cycle.

Fed Funds And Global Markets

What does this mean for equity markets? We follow a lead from our European strategy team

The message is encouraging. Global equities have risen by an average 18.4% in the 12 months following the Fed?s first cut. The initial response to the first cut is uncertain (see Figure 1. Global Equity Performance In 12m Following the First Fed Cut (14 Samples Since 1974) on the front page), probably because investors are still worrying about

The success rate is impressive. Of the 14 rate-cutting phases that we have looked at, 12 have seen a positive return from global equities over the next 12 months. That figure falls to 9 successes if we look at 1 or 3 month returns, again suggesting that it may take more than one cut for the equity markets to make a decisive move.

So far, so good. Investors who bought global equities as the Fed cut would have had a very good chance of making excellent returns. But we could have done this analysis in 2001 and suggested that equity investors had a 12/13 (92% sounds even more impressive) chance of making money over the next 12 months. Unfortunately, the global equity market fell 17%.

1998 or 2001?

So we need to be more specific. It?s no use saying that an investor now has a 12/14 chance of making money, if the next time we come to write this analysis in the next Fed cutting cycle we have to say that there is a 12/15 chance. To improve our success rate, we examine the periods when it was wrong to buy as the Fed cut. What made 2001 (when the market fell 17%) different to 1998 (when the market rose 29%).

To do this, we have added some extra data to our analysis. We show the shift in earnings in the 12 months after the first rate cut. We also look at equity valuations at the time of the cut.

Both of the periods of negative 12 month returns (1981 and 2001) were associated with falls in corporate earnings. But there are also three rate-cutting phases where falling earnings did not stop markets rising (1974, 1982 and 1998). High valuations have not necessarily preceded weak returns. For example, the global equity market traded on a multiple of 18x or above in each of the five rate-cutting phases between 1987 and 1998, but still managed to make positive returns in the following 12 months.

With hindsight, 2001 looked dangerous. Trailing P/Es were down from the 31x bull market peak but still high at 23x. And global corporate earnings fell by 14% over the following 12 months. This toxic mixture of high valuations and collapsing corporate profitability meant that the Fed?s liquidity injection didn?t turn the equity market. By contrast, in 1998 the global equity market was trading on a high, but not unprecedented valuation, and earnings fell but did not collapse.

1998 also shows one characteristic that seems common in those periods where Fed cuts have benn associated with strong returns over the next 12 months ? the peak/trough rate reduction has been below average (330bp). A few cuts in rates are nice, but anything much more might reflect more fundamental problems that could severely undermine the corporate earnings base. Indeed, the global equity market has returned an average 28% in the 12 months following the start of peak/trough reduction in Fed funds below 330bp, with none of the periods generating a negative return. In the periods where rates fell more than 330bp, the average returns drops to 9% and two have generated negative returns.

What About 2007?

What strategy does our analysis suggest that we should adopt right now? We are inclined to be bullish ? Fed fund cuts have generally been positive for global equity markets. But we would have been burnt by that view in 2001.

How can we be sure that the same factors that ambushed this strategy in 2001- 02 won?t get us again in 2007-08? First, we are reassured by valuations. The current trailing P/E of 16x compares favourably to the 23x seen in 2001. In fact, the current global multiple is the lowest seen in any of the Fed rate-cutting phases since 1985.

But what about the other sensitive factors ? earnings and the magnitude of the peak/tough rate cuts? These are, of course, related. A sharp fall in earnings would presumably reflect a weak global economy and trigger a more aggressive response from the Fed and other central banks.

Right now, we predict neither of these. Currently, our aggregation of IBES consensus estimates suggests global earnings growth of 12% over the next 12 months. This is probably too high, and likely to fall as the impact of the current financial malaise is reflected in forecasts. But this also provides us with a significant buffer before we actually start to predict a

So, precedent suggests that it has not been enough to say that earnings expectations are too high to be bearish as the Fed cuts. It is not even enough to say that earnings could actually fall over the subsequent 12 months. They did exactly that in 1974-5, 1982-3 and 1998-9 but global equities actually rose significantly over each period. Instead, to be bearish on the market, investors probably need to be expecting a very significant (at least 10%) fall in earnings given current valuations. We attach a low probability to that outcome.

Also, healthy returns have followed the Fed response to sudden financial panics (1987, 1998). Perhaps markets force central banks to over-react in order to get their fix of cheap money.

Overall, we would see the Fed cuts as positive for global equity markets. Valuations do not look particularly stretched. Earnings estimates may be too high, but that has not prevented strong returns in the past.

Regional And Sector Performance

We can then look at regional performance in the 12 months following the rate cuts (Figure 5). On average, there has not been huge divergence in returns following the Fed?s first move. The US has lagged, up ?only? 15% in the next 12 months. Europe has been the best performer, up 21% over the period. But the data is very volatile, with Asia Pac tending to be the highest beta play on these Fed induced rallies in the past decade.

One fairly consistent theme has been the underperformance of the US. Even though the US central bank may have been the initial source of monetary stimulus, it has provided the greatest benefit to markets elsewhere. It pays to buy assets which benefit from the positive impact of lower rates while minimizing the impact of why rates are being cut in the first place. This is a classic free-rider strategy.

We can also look at global sector performance following rate cuts. All have generated good positive returns, but Financials have done best. They often lead any sell-off before the central bank move, and may consequently suffer earnings downgrades, but they also have the most to gain from the interest rate response.

Some Stock Ideas

So it seems that US stocks have underperformed in the 12 months following the first Fed cut. Financial stocks have outperformed. That suggests that a portfolio of Non-US Financials may be best placed to benefit from the cuts in Fed funds now being forecast by our economists.

We have screened CIR?s research universe for ex-US financials which are buyrated by our analysts, look reasonable value on a P/E and P/BV basis, have decent earnings momentum but have not outperformed the global equity market over the past month.

This is not a list for the faint-hearted - there may be bad news to come from these names. Indeed, we would prefer to buy them into further weakness over the next couple of months. But they should be well placed to benefit once the global equity market has taken a more decisive stance on the impact of lower US rates.

Strategy Outlook

Our economists now expect the Fed to cut by 75bp in response to the current financial threat to US and global economic stability. They expect the first move on or even before the September 18

Our analysis comes up with some clear strategy messages. The first is to buy equities as the Fed cuts. Precedent and reasonable valuation suggest that the odds are more in the bulls? favour than back in 2001. From a timing perspective, it may be better to buy on the second or third cut.