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The Fed is tightening the interest-rate screw. What now?

The US Federal Reserve initiated a new rate-hiking cycle in March and looks set to soon further accelerate the pace of returning its monetary policy to normal. What does this mean for financial markets? No two cycles are ever the same, so a concrete forecast cannot be derived from interest-rate history. However, looking back at the past helps to form an expectation. Our conclusion is that equity markets are likely to remain volatile. Yet there is hardly a way around stocks.

 

The phase of (ultra)low interest rates is over

In autumn of last year, the financial markets were anticipating just two quarter-point rate hikes by the US Federal Reserve for 2022. A half-year later, the situation now looks completely different. In March, the Fed fired the starting gun for a new rate-hiking cycle. And not just that, a projected interest-rate rise totaling more than 200 basis points by year-end has since been priced in by the market in the meantime. What’s more, the upcoming rate hikes are unlikely to all be small ones. A big 50-basis-point hike at the next FOMC meeting in early May is practically a foregone conclusion because even the “doves” among Fed officials have recently spoken out in favor of speeding up the pace of returning monetary policy to normal. Even the last Fed officials evidently see the US central bank behind the proverbial curve by now. If the federal funds rate actually rises as quickly as currently anticipated by market participants (and by the Fed itself), then around a year from now the policy rate in the USA will likely already be at the “neutral” interest-rate level that is neither too hot (restrictive) nor too cold (stimulative) for the economy. The Fed recently estimated that level at 2.4%. The million-dollar question now is: What do the rate hikes mean for the (equity) markets?

 

Fast regime change
Interest-rate expectations have risen considerably

Expected number of (25-basis-point) rate hikes by end-2022

 Sources: Bloomberg, Kaiser Partner Privatbank

 

Behind the curve
The Fed will increase the pace

Expected number of “small” rate hikes (cumulative) at the upcoming Fed meetings

Sources: Bloomberg, Kaiser Partner Privatbank

 

Don’t trust a statistic…

No two interest-rate cycles are the same. They differ from each other by duration, speed, the starting point of the policy rate and especially by the macroeconomic climate in which the cycles occur. Since every cycle is ultimately unique, it is hardly possible to derive a sound forecast for the future from interest-rate history. Moreover, there have only been 13 “proper” rate-hiking cycles (i.e. ones consisting of more than single rate hikes) in the last 80 years, so the data sample size is limited. Nevertheless, taking a look back at the past can help to form an expectation of how asset markets may potentially perform in the quarters ahead. The maxim here, though, is: “Don’t trust a statistic that you haven’t rigged yourself.” When analyzing past interest-rate hikes, there are many different ways to work with the available data and to arrive at different findings as a result. What time frame do you factor in? Does a single rate hike alone constitute an interest-rate cycle? And what (policy) interest rate do you use as a reference? Given the broad (manipulation) latitude, it makes sense to look as far back as possible at the history of the Fed’s interest-rate policy and to analyze it as granularly as possible. The analysts at Ned Davis Research (NDR) took on this challenge and begin their analysis back in the mid-1940s, differentiating between slow cycles (those with occasional lengthy pauses between rate hikes), fast cycles (those with rate hikes at (almost) every FOMC meeting) and single rate hikes (non-cycles). We replicated this analysis for this article.

 

Apples and oranges
Every rate-hiking cycle is different

Rate-hiking cycles since 1994

Sources: Bloomberg, Kaiser Partner Privatbank

 

Speed (among other things) matters

Let’s skip straight to the findings: Regardless of whether rate hikes were slow, fast or one-offs, US stocks rose by more than 10% on average over the twelve months prior to a rate hike. The latest interest-rate cycle also fits with this pattern. What happened after an initial rate hike depended in good part on the speed of the cycle. Averaging out the observations over the last 80 years reveals that prices on the US equity market were (significantly) higher both twelve and 24 months after an initial rate hike. But when a rate-hiking cycle proceeded quickly and the Fed progressively tightened the interest-rate screw at each FOMC meeting, stocks had a bit more difficulty climbing over the next two years.

What can be inferred from the rate-hiking cycle just recently initiated? Arguably the most likely inference is that equity markets will stay on the volatile side in the quarters ahead because as we described at the outset of this article, we can expect to see swift and sharp interest-rate hikes in the near future. We could already even find ourselves back in tightish interest-rate territory in the USA by mid-2023. In addition, market participants have to adjust not only to higher interest rates, but also to rapid quantitative tightening as the Fed shrinks its balance sheet. But the statistics also contain a silver lining because this time, almost a complete rate-hiking cycle was already priced in at the time of the initial rate hike, which means that the correction phase typically seen in the first six months of a fast cycle (see chart) may have already taken place. In any case, the S&P 500 index already fulfilled its historical correction “quota” with its recent intermittent plunge by around 13%.

 

Fast(er) rate hikes…
…cause bigger bellyaches

Performance of S&P 500 index before and after interest-rate hikes

Sources: Bloomberg, NDR, Kaiser Partner Privatbank

 

Stocks continue to belong in portfolios

Higher volatility and lower returns than in the last three years – there is certainly nothing wrong with looking ahead to the future with this expectation. But it would definitely be inappropriate to speculate on a bear market now solely on the grounds of lofty inflation and the necessary response to it by central banks. There would be a substantial probability of a stock-market correction of more than 20% only in the event of a recession. Although signs of a recession occurring in the next three years are gradually mounting – one of the signs being the US yield curve, which recently caused a commotion again (and thus merits an article devoted to it from us soon) – there is little suggesting that it will happen within the next twelve months.

So, even though monetary policy is becoming more restrictive, our medium-term outlook for stocks remains constructive because gauged in terms of real interest rates, which are still in negative territory in industrialized countries, the monetary climate remains accommodative for stocks. Furthermore, stocks are no longer overpriced in the wake of the correction in recent weeks and even have cheapish valuations in some regions. And relative valuation metrics like equity risk premiums and the spread between dividend and fixed-income yields (particularly in Europe) also indicate that stocks are still a comparatively better investment than bonds.

 

No longer overpriced
Valuations have corrected

Price-earnings-ratio

Sources: Bloomberg, Kaiser Partner Privatbank

 

Stocks remain (more) attractive
Bonds are not an alternative yet

Dividend yield vs. bond yield

Sources: Bloomberg, Kaiser Partner Privatbank

 

Oliver Hackel, CFA Senior Investment Strategist

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