Fighting the Fed
The wisdom on Wall Street is “Don’t fight the Fed”.Late in January the CEO of Cisco Systems announced that revenue growth had slowed abruptly in the New Year and that the next two quarters could be a rough ride. Press coverage was extensive on the Monday– but Cisco’s share price barely moved.
A fortnight later and Cisco Systems reported its quarterly results revenue growth had hit a brick wall in January. In the current quarter revenue growth would be zero or negative. The shares fell over 20% and brought many other technology stocks down in its wake. Don’t fight the Fed?
This episode illustrates a severe misconception at the heart of the current debate on interest rates etc. The ‘don’t fight the Fed’ consensus rests on two assumptions. The first is that falling interest rates are good for markets. The second is that cyclical stocks begin to rally well before the beneficial economic effects of lower interest rates are evident. This is being used to justify the argument to buy technology stocks.
The first point is undeniable. Falling rates are generally positive for markets although circumstances differ and the gap between interest rate cuts and a sustained market rise can be quite substantial. The second point is the more debatable. Interest rates may well stimulate the consumer and general economy quite quickly. However, capital expenditure is typically much later cycle and does not respond promptly to cuts in short term rates. In other words, whilst tech stocks might be GDP-sensitive they are not in any way early-cycle.
Moreover, the after-effects of the technology bubble are becoming more apparent. Economic cycles almost always end with a bulge in capital expenditure. Companies tend to feel most optimistic after several years of growth and behave accordingly. This cycle was longer and stronger. Moreover we were led to believe that it wasn’t a cycle at all but a new paradigm. The Goldilocks Economy – not too hot, not too cold – would just go on and on. Hence the normal bulge in capital expenditure became a bubble. Whereas in previous cycles liquidity and debt had funnelled into areas such as real estate (US 1985) or energy (US late 1970s), this time the cash poured into technology and communications.
By definition, a lot of this money has been wasted. Since much of this was borrowed money, much of this debt will need refinancing (ultimately through equity issuance). We are less than 12 months into this process. The Federal Reserve’s rate cuts have little to do with it one way or the other.
There’s no need to be too despondent. We already have a new bull market underway. The UK market ex TMT has already broken into new high ground. The market can make modest progress this year – but it may be hamstrung by the delayed rights issue effect of refinancing excess investment in certain ‘hot’ sectors of the economy.
Michael Taylor is investment director at Zurich Scudder Investments in London