Generally speaking, higher interest rates benefit stocks

Fed rate cuts are of little importance to investors because they do not directly drive stocks.

Still, investors are concerned about central bank interest rate cuts. All you have to do is google "Fed cuts" and the page is filled with videos and news stories speculating on the intentions of Chair Powell and the rest of the Fed Board to cut interest rates. The economic data is reflected lightning-fast in in the market's predictions of future central bank rate movements. Europe, with its weaker economy, is wondering whether the ECB will dare to cut policy rates before the Fed, which is enjoying a strong US economy.

Policy rates are used by central banks to influence the state of the economy: high rates discourage borrowing and thus economic activity, while low rates try to stimulate investment through cheap bank loans.

However, the policy rates set by the Fed, or any other central bank, are not the primary driving force for the market.

In the long run, stocks follow the results. The present value of a company is the market's best guess at any given moment of its future cash flows, with some demanded return, i.e., interest calculated to the present day. This is logical, because it would be silly to knowingly pay more for a company than it can transfer cash to its buyer.

In practice, the return potential of stocks is measured against the risk-free interest rate on government bonds. Interest rates on government bonds are determined by supply and demand. They are an indication of how much investors want in return for lending money to governments for years at a time.

Government bond rates also contain other information. In effect, they reflect investors' perception of future nominal economic growth. In other words, real GDP growth and inflation. (Riskier borrowers like Italy have an additional interest rate premium over "risk-free" goofballs like Germany, but in practice investors always have the option of parking their money in low-risk borrowers like Germany or the US, so let's just focus on them here.)

It is no coincidence that over the past 50-plus years, while the interest rate on the US government debt has averaged 6%, the country's nominal GDP growth has also been 6% per year! Over the same period, the S&P 500's earnings per share (or index share) growth has been just under 8%. The difference can probably be explained by improved profitability of companies, growing profit share of GDP, international growth, and share buybacks. But in practice, they are operating in the same ballpark.

A few conclusions can be drawn from this observation. Low interest rates are often portrayed as a good thing for stocks. But what do low interest rates mean? They mean that investors' expectations for future economic growth (and/or inflation) are modest. This also means that companies' earnings growth will be slow. No company can grow faster than GDP forever. Thus, low interest rates also imply low earnings growth in companies' long-term cash flows, which is already reflected in equity valuations today.

The performance of equity markets in Europe and the rest of the world in the aftermath of the financial crisis was a good illustration of this. European and global equity performance stagnated for more than 10 years. Even though the interest rate on German government debt went negative, i.e. investors paid for the "privilege" of lending to the federal state of Germany, stocks did not soar to infinity. The same goes for Japan, where stocks languished in the swamp of low interest rates for decades.

Of course, many markets are driven by the global economy as a whole, and a weak economy and low interest rates in a single country are not the only explanation for the level of the stock exchanges.

Instead, even European stock markets have now rocketed, while interest rates are at a higher level.

The United States has been the exception that proves the rule. There, even with "zero interest rates", GDP growth was bobbing along at a couple of percent. S&P 500 companies were able to continue their earnings growth, and to boot, the country was blessed with a number of technology mega-winners, such as Apple or Microsoft, which are able to capture more of the value added as the economy becomes more digital.

Higher interest rates would be toxic if they simply implied high inflation without strong economic growth. That is what happened in the stagflation of the 1970s. But that does not seem to be a likely scenario now.

Aswath Damodaran, considered a leading expert on valuation, said well in an interview with the FT in March that the current interest rate of just over 4% on US bonds is ideal. It provides a return on cash that discourages investors from doing stupid things. On the other hand, it points to stronger economic growth in the future, which in turn will allow for faster earnings growth.