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Written by: Jacob Johnston | Advisor Asset Management
The June 16 Federal Open Market Committee forecast showed the majority of policy makers expected it would be appropriate to begin raising the central bank’s benchmark federal funds rate from its current near-zero level sometime in 2023 and the majority of them believe the central bank will hike at least twice that year. Seven of the 18 members see the Fed possibly increasing rates as early as 2022. This hawkish shift rattled the equity markets as the S&P 500 dropped 1.91% that week and the Dow Jones Industrial Average fell 3.45%, its largest weekly drop since October of last year.
Fortunately for equity investors we have a recent case study to provide a road map for what might transpire during a forthcoming tightening cycle. Recall the Fed dropped its target rate to zero for the first time ever in December 2008 in response to the Credit Crisis. The Fed maintained the zero-interest-rate-policy for seven years before an initial rate hike in December of 2015 which began a tightening cycle that included nine hikes over roughly three years and brought the target rate as high as 2.50%.
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Federal Funds Target Rate History |
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16-Dec-08 |
0.00-0.25% |
|
26-Sep-18 |
2.00-2.25% |
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16-Dec-15 |
0.25-0.50% |
|
19-Dec-18 |
2.25-2.50% |
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14-Dec-16 |
0.50-0.75% |
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31-Jul-19 |
2.00-2.25% |
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15-Mar-17 |
0.75-1.00% |
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18-Sep-19 |
1.75-2.00% |
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14-Jun-17 |
1.00-1.25% |
|
30-Oct-19 |
1.50-1.75% |
|
13-Dec-17 |
1.25-1.50% |
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3-Mar-20 |
1.00-1.25% |
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21-Mar-18 |
1.50-1.75% |
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15-Mar-20 |
0.00-0.25% |
|
13-Jun-18 |
1.75-2.00% |
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|
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Source: Bloomberg
Leading up to and during the tightening cycle, many thought the Fed policy could spell the end of what was a multi-year bull market. However, thanks to a great deal of transparency, the stock market was able to digest the rate hikes and continue to trend higher. Throughout the roughly three-year tightening cycle the S&P 500 gained 28.59%, or 8.71% annually from 12/16/15-12/19/18.
Investors currently find themselves in a similar situation as back in 2015 with the economic recovery from the COVID-19 pandemic well under way and the Fed signaling rate hikes are on the horizon. Let’s assume the June forecast for two rate hikes in 2023 is accurate. That puts us at a minimum of approximately 18 months away from a January 2023 move from the FOMC. Looking at equity returns in the 18 months prior to the initial rate hike in December 2015 could be useful for investors today.
Source: Bloomberg
Equity Returns 18 Months Pre-Initial Rate Hike (6/16/14-12/16/15)
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INDEX |
DESCRIPTION |
TOTAL RETURN % |
|
S&P 500 |
Large-cap |
10.35 |
|
Russell 2000 |
Small/Mid-cap |
0.47 |
|
Russell 1000 Growth |
Growth |
15.63 |
|
Russell 1000 Value |
Value |
3.11 |
|
Dow Jones Select Dividend |
Dividend Stocks |
6.14 |
Source: Bloomberg
Looking at the table above of broad category performance in the months leading up to rate liftoff in 2015 shows positive returns across the board, and relative strength from Large-cap and Growth stocks.
The table below looks at the 12-month period after the initial rate hike in December of 2015. We see positive returns across the board in this period as well, but relative strength from Small/mid-cap and Value stocks.
Equity Returns 12 Months Post-Initial Rate Hike (12/16/15-12/16/16)
|
INDEX |
DESCRIPTION |
TOTAL RETURN % |
|
S&P 500 |
Large cap |
11.33 |
|
Russell 2000 |
Small and Mid-cap |
20.53 |
|
Russell 1000 Growth |
Growth |
6.52 |
|
Russell 1000 Value |
Value |
16.81 |
|
Dow Jones Select Dividend |
Dividend Stocks |
22.01 |
Source: Bloomberg
This recent case study is a timely example, but it is also supported by a larger sample size on a similar topic. Ned Davis Research identified 20 instances since 1928 of initial Fed rate hikes after at least one rate cut. The S&P 500 saw positive returns in the 12 months following the initial rate hike 14 out of 20 times (70%) with a median return of 7.1%.
As we enter the second half of the year and move into 2022, we expect to hear a lot of noise about rate hikes as the Fed tries to balance the economic recovery. Our message is the same today as it was in 2015 when faced with a similar environment – historical returns suggest the broad equity market tends to rise even when the Fed embarks on a rate-hike cycle and investors who maintain diversified equity exposure could potentially be rewarded.
Related: The Great Transitory Debate: Breaking Down the Latest Inflation Numbers