Why ASX shares don't need interest rate cuts to rally

Everyone is focused on interest rates. But are cuts necessary?

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2024 has been a volatile year for the ASX share market so far, with interest rates and inflation continuing to affect markets.

The S&P/ASX 200 Index (ASX: XJO) has fallen 2.6% since 10 April 2024, though it's still up more than 9% over the past six months despite the recent decline.

Let's look at what may have caused the recent decline.

US inflation continues to be strong

The US Federal Reserve is seen as the most important central bank in the world because of how large the US economy is and how much influence the US stock market and US dollar have on the world.

Officials in the US, like in Australia, have had trouble keeping inflation under control. The latest inflation print in the US showed a 3.5% rise in March, which was higher than expected and an increase in inflation, according to reporting by CNBC.

Jerome Powell, the boss of the US Federal Reserve, said inflation hadn't reduced to its goal target, so it may take longer for interest rate cuts to occur. Powell said:

The recent data have clearly not given us greater confidence, and instead indicate that it's likely to take longer than expected to achieve that confidence.

Why do interest rates rates matter to investing? It's because interest rates affect valuations, they act like gravity on asset prices – the higher the rate, the more it should pull down on asset prices.

Do interest rates matter for ASX shares?

Interest rates have remained at their high level during this period of share prices going upwards. Cuts didn't come through, yet the rally happened.

The Australian Financial Review reported on comments from John Pearce, UniSuper's chief investment officer, who said:

For the life of me, I don't see how central banks in the US and Australia can contemplate rate cuts when your labour market is so strong.

BHP at $45, is that a bubble? No way, right? So I think the rally is built on pretty sustainable grounds. The question though, is, of course, what happens to inflation? If you knew that number, you can be a very rich person. Everything swings on US inflation.

I'd argue that some of the recent rally was due to investors becoming confident that cuts were coming sooner rather than later. Now that imminent cuts seem unlikely, investors are seemingly reassessing what valuations make sense for today.

Why I don't think rate cuts are needed

I think the recent decline is a sign that investors are reassessing what the appropriate price/earnings (P/E) ratio is for the market.

Once the market has finished adjusting to a new (potentially lower) earnings multiple for a company, the share price can then be driven higher by earnings growth. Earnings-driven share price growth doesn't require the P/E ratio to increase.

Share price increases driven by rapid P/E ratio growth can be unsustainable if it isn't backed up by profit growth in subsequent results.

While the ASX 200 is only down by a few percent, there are quite a few other quality S&P/ASX 300 Index (ASX: XKO) shares that have dropped 10% or more in the last few weeks. I'd suggest that's where there are great buy-the-dip ASX share opportunities right now because of their longer-term earnings growth potential. Personally, I've been using this decline to buy ASX shares.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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