By the end of the year, investors will likely be contending with the first Federal Reserve (Fed) rate hike in nearly a decade.
While the pace of monetary tightening is likely to be gradual, more than a few investors are worried about the equity impact of any marginal tightening, believing that the entire edifice of today’s bull market has been built on a foundation of cheap money.
I would agree with the view that monetary policy has been one of the principal catalysts and sustainers of this bull market. But as I write in my new Market Perspectives paper, “No Exit,” I’m skeptical that an initial rate hike will herald the end of the rally, though history does suggest that it could result in a modest correction.
Not only is any tightening likely to be gentle and from an exceptionally low base, but tighter monetary conditions are generally associated with more volatility and downside risk, not bear markets.
When you look at S&P 500 performance during rate cycles for various periods going back to the 1970s, a clear pattern emerges. Regardless of the period, 3-month returns following the start of a period of steady tightening were on average negative and more volatile, as markets initially reacted negatively to the start of a tightening cycle. However, looking out at 6 or 12 months, markets rebounded and generally produced positive, albeit subpar, returns. The chart below looking at forward 3-, 6- and 12-month returns on the S&P 500 following an initial change in the Federal Funds target rate shows this pattern.
Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
The averages above do hide a significant amount of variation in returns, and the direction of equity valuations at any given point in time also matters. Indeed, in the past, U.S. equity markets have been more resilient to tightening monetary conditions if valuations were flat or lower over the preceding 12 months. But if valuations had been rising in the previous year, the S&P 500 has historically performed much worse following the start of a tightening cycle.
Put differently, markets characterized by multiple expansion—in other words, when investors are paying more per dollar of earnings—are more vulnerable to a change in monetary conditions. The fact that U.S. equity multiples have been consistently rising since 2011 suggests that markets are at greater risk for at least a modest correction following a rate hike. In addition, one area of the market – namely small caps – may be particularly vulnerable and warrants caution. Historically, small caps have been more sensitive than large caps to the reduction in returns associated with monetary tightening.