It’s extremely anticipated that the Federal Reserve will decide to cut the federal funds rate by 25 basis points (bp) during its appointment on Wednesday, July 31, 2019. Goldman Sachs believes that stocks are near “fair value” given the modish level of interest rates, but they indicate that a rate cut can bolster the market in 5 ways, given its likely propitious impacts on valuation multiples, share repurchases, R&D, M&A, and capital expenditures (capex).
“From an investor’s perspective, lower quicken rates increase the value of equities, all else equal. More than 95% of the S&P 500’s YTD climb has been driven by an enlargement in P/E multiples as 10-year U.S. Treasury yields fell and the P/E multiple expanded from 14x to 17x,” Goldman writes in the current edition of their U.S. Weekly Kickstart broadcast. “From a corporate perspective, lower interest rates increase the capacity of firms to invest for growth and return notes to shareholders,” they add.
Significance for Investors
“Today, our macro model indicates that [the] S&P 500 trades near lawful value when considering the low level of interest rates,” Goldman writes. However, they do not forecast precisely how much bearing a 25 bp rate cut should have on stock prices, if any.
Goldman views capex, R&D, and cash M&A collectively as “investment for flowering.” Looking at history from 1995 onwards, they find that rate cuts by the Fed have tended to goad such investment in the short term, since they reduce financing costs and hurdle rates, the latter being the minutest return that an investment must generate to be considered profitable.
“Beyond the first three quarters [after a value cut], the path of spending was determined by the health of the U.S. economy…Our economists see a low probability of recession in the near term, which supports our seascape that investment will continue to grow. We estimate S&P 500 capex (+8%), R&D (+9%), and cash acquisitions (+13%) see fit all grow during 2019.”
Regarding share repurchases, also called stock buybacks, Goldman calculates that YTD spendings through mid-July are up by 26% on a year-over-year (YOY) basis. They project that spending on buybacks will be up by 13% for engaged year 2019 versus 2018, reaching a new annual record of $940 billion.
“However, for the first time in the post-crisis duration, companies are returning more cash to shareholders than they are generating in free cash flow (FCF),” Goldman give prior notices. To finance buybacks, dividends, and investment, non-financial S&P 500 companies have reduced their cash balances during the endure 12 months by $272 billion, or 15%, the largest percentage decline since at least 1980.
Meanwhile, corporate leverage has floated to a new all-time high in 2019. The upshot is that future outlays on investment and on returns of cash to shareholders are likely to deal constraints.
Looking Ahead
Goldman writes: “Looking forward, stocks with weak balance sheets should improve from a modest acceleration in the pace of U.S. economic growth. Weak balance sheets trade at a significant discount built on forward P/E to stocks with strong balance sheets (15x vs. 25x) and are expected to generate equivalent EPS growth during 2019 (+7%). In spite of that, our economists’ view that the Fed will be less dovish than implied by market prices represents a risk to go oned weak balance sheet outperformance.”