If you think a rate cut by the Federal Reserve would boost the stock market, think again, UBS warned.
In fact, the S&P 500 has fallen slightly since the central bank delivered the first rate reduction in more than a decade in July. That's because the correlation between the S&P 500's price-earnings ratio and the Fed funds rate has broken due to the long period of low rates since the early 2000s, UBS noted
"Fed rate cuts are not likely to fuel equities higher as they did in the 1990s," UBS equity strategist Francois Trahan said in a note on Tuesday. "The Fed-easing rallies of the 1990s were made possible by a strong inverse correlation between interest rates and P/Es. This relationship no longer exists today."
Stocks just finished a volatile third quarter with the S&P 500 still eking out a small gain. Investors had a choppy ride over the past few months with the escalated trade war taking a bite from the economy. The U.S. manufacturing sector contracted in August, its first decline since 2016, according to a gauge from the Institute for Supply Management.
ISM's new export orders also slowed to their lowest reading since April 2009, which is an important signal as the decline has historically been coincided with S&P 500 earnings growth turning negative, the analyst pointed out.
"Investor sentiment has been resilient in the face of the ISM crossing below 50 in August. We believe this resilience in sentiment is explained by the widespread belief that Fed rate cuts will help support S&P 500 P/Es as they did in the 1990s," Trahan said.
Traders are now pricing in a 40% chance of a rate cut at the end of October and about a 67% probability of at least one rate reduction in December, according to CME FedWatch tool.
Optimism for a rate-cut rally should be further diminished in the face of heightened political uncertainty, Trahan warned.
"Uncertainty at the White House continues to increase perception of risks," Trahan said. "Add to the mix an official impeachment inquiry into President Trump and this will likely exacerbate the headline volatility we've seen in equities."