How Do Lower Rates Stimulate Economic Growth?
Sources: Sources for data in tables: Equity Market and Fixed Income returns are from JP Morgan as of 07/12/19. Rates and Economic Calendar Data from Bloomberg as of 07/12/19. International developed markets measured by the MSCI EAFE Index, emerging markets measured by the MSCI EM Index. Sector performance is measured using GICS methodology.
Global capital markets were mixed on the week as investors digested favorable economic data and dovish central bank commentary. In the U.S., the S&P 500 Index pushed ahead to a level of 3014, representing a gain of 0.82%, while the Russell Midcap Index gained 0.51% for the week. The Russell 2000 Index, a measure of the Nation’s smallest publicly traded firms, lost 0.34%. On the international equities front, developed markets moved 0.54% lower, while emerging markets fell 0.75%. Finally, the 10 year U.S. Treasury yield was unchanged on the week closing at 2.12%.
It seems fairly evident, following Federal Reserve Chairman Jerome Powell’s commentary last week, that the Federal Reserve will, in-fact, cut short-term interest rates on July 31st. When the Federal Reserve decides it’s necessary to stimulate economic growth through monetary policy they cut interest rates by lowering the Federal Funds Target Rate. They do so with the intention of easing borrowing standards for three vital cohorts: businesses, consumers, and the government. Considering that every financial news outlet has covered the Fed’s pending interest rate movement ad nauseam, we believe that it would be useful to describe the mechanisms that transmit these interest rate cuts into economic growth.
1. Business Spending -> Lower interest rates provide incentives for businesses to borrow and invest those borrowed funds potentially into new projects. This increase in capital spending should lead to increased hiring, which may lead to increased consumer spending.
2. Consumer Spending -> Lower short term rates lead to lower mortgage and credit card interest payments, allowing consumers to potentially increase their level of consumption. This is particularly important considering that consumer spending accounts for roughly 68% of Gross Domestic Product (GDP).
3. Government Spending -> Decreased short term rates allow governments, just like businesses and consumers, to borrow more for less. Ultimately this can lead to amplified government spending, which would result in higher GDP, all other things held constant. While not as important to economic growth as consumer spending, government spending still accounts for approximately 17% of GDP.
Only time will tell if this round of interest rate cuts will provide the degree of stimulus expected and/or desired, but in the meantime we encourage investors to stay disciplined and work with experienced financial professionals to help manage their portfolios through various market cycles within a well-diversified framework that is consistent with their objectives, time-frame and tolerance for risk.
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MSCI- EAFE: The Morgan Stanley Capital International Europe, Australasia and Far East Index, a free float-adjusted market capitalization index that is designed to measure developed-market equity performance, excluding the United States and Canada.
MSCI-Emerging Markets: The Morgan Stanley Capital International Emerging Market Index, is a free float-adjusted market capitalization index that is designed to measure the performance of global emerging markets of about 25 emerging economies.
Russell 3000: The Russell 3000 measures the performance of the 3000 largest US companies based on total market capitalization and represents about 98% of the investible US Equity market.
ML BOFA US Corp Mstr [Merill Lynch US Corporate Master]: The Merrill Lynch Corporate Master Market Index is a statistical composite tracking the performance of the entire US corporate bond market over time.
ML Muni Master [Merill Lynch US Corporate Master]: The Merrill Lynch Municipal Bond Master Index is a broad measure of the municipal fixed income market.
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LIBOR, London Interbank Offered Rate, is the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London.
The Dow Jones Industrial Average is an unweighted index of 30 “blue-chip” industrial U.S. stocks.
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DJ Equity REIT Index represents all publicly traded real estate investment trusts in the Dow Jones U.S. stock universe classified as Equity REITs according to the S&P Dow Jones Indices REIT Industry Classification Hierarchy. These companies are REITs that primarily own and operate income-producing real estate.