On Wednesday, July 31, 2019, the FED decided to cut the federal fund rate by 25 basis points (bp).
According to Goldman Sachs, stocks are rated “near fair value”; this view is based on the present interest rate conditions and they see 5 positive means (as a result of the rate reduction) for the stock market valuation, i.e. attractive valuation multiples, renewed share repurchase programs, attractive capital raising conditions for M&A, attractive capital raising conditions for Capex, attractive conditions for R&D.
“From an investor’s perspective, lower interest 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 expansion 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 report. “From a corporate perspective, lower interest rates increase the capacity of firms to invest for growth and return cash to shareholders,” they add.
Goldman views capex, R&D, and cash M&A collectively as “investment for growth.” Looking at history from 1995 onwards, they find that rate cuts by the Fed have tended to stimulate such investment in the short term, since they reduce financing costs and hurdle rates, the latter being the minimum return that an investment must generate to be considered profitable.
“Beyond the first three quarters [after a rate 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 view that investment will continue to grow. We estimate S&P 500 capex (+8%), R&D (+9%), and cash acquisitions (+13%) will all grow during 2019.”
Regarding share repurchases, also called stock buybacks, Goldman calculates that YTD outlays 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 full year 2019 versus 2018, reaching a new annual record of $940 billion.
“However, for the first time in the post-crisis period, companies are returning more cash to shareholders than they are generating in free cash flow (FCF),” Goldman warns. To finance buybacks, dividends, and investment, non-financial S&P 500 companies have reduced their cash balances during the last 12 months by $272 billion, or 15%, the largest percentage decline since at least 1980.
Looking Ahead
Goldman writes: “Looking forward, stocks with weak balance sheets should benefit from a modest acceleration in the pace of U.S. economic growth. Weak balance sheets trade at a significant discount based on forward P/E to stocks with strong balance sheets (15x vs. 25x) and are expected to generate equivalent EPS growth during 2019 (+7%). However, our economists’ view that the Fed will be less dovish than implied by market prices represents a risk to continued weak balance sheet out performance.”