We recently discussed whether the US Federal Reserve would pause on their interest rate hikes or continue, also discussed was the effect that a potential pause may have on the stock market. We are going into further detail on this now that the Fed has paused on the interest rate in the wake of the ongoing inflation deceleration.
Inflation vs Interest rate
On June 14th 2023, the US Federal Reserve (Fed) opted to leave interest rates unchanged at 5,25% for the first time since February 2022 (following 10 consecutive prior increases). The so-called pause comes after US inflation was down to 4,0% for May 2023 from its peak of 9,1% in June 2022. The consecutive rate hikes spanning over the past 15 months was imposed to combat the highest level of inflation in the US for 40 years and bring down inflation to their annual target of 2%.
Factors that may have influenced the Fed’s decision to pause can be traced to failures of three US Banks (Silicone Valley Bank, Signature Bank and First Republic Bank) this year and uncertainty around a substantial slowdown in the US housing market due to the rapid pace of mortgage rate increases.
The theme of inflation versus interest rates in the US has dominated the macroeconomic agenda since the Fed began their rate hike in Feb 2022, the fastest rate hike in recent US history as shown by the chart below.
Likely Future Hikes
Whilst there was a unanimous decision to pause on the interest rate at this point in time, there is still indecision on whether the June 14th 2023, announcement is the peak as the Fed indicated that they would raise interest rates another two times by 0,25% each before the end of 2023 (bringing interest rates to 5,75%). Investors anticipate a 74.4% probability of the Fed hiking rates by a quarter point at its July 25-26 meeting, according to the CME FedWatch Tool.
Whether that announcement was to allow themselves more time to make a decision rather than seeing the economy begin to speed up again just as they have begun to tame inflation is another debate.
Stocks After Rate Hikes
The question we’re interested in is: What happens to equities if (or when) the Fed is indeed done raising interest rates?
The increased interest rates make it more difficult and expensive for companies to use debt as a form of capital. This in turn, affects a company’s ability to expand or grow as their access to funding becomes limited. Consequently, both businesses and consumers are likely to cut their spending resulting in declines of both earnings and stock prices.
However, markets are forward looking. Once investors are comfortable that interest rates have peaked, and that there are higher potential future earnings as a result, their sentiment shifts leading to higher consumer confidence and increased spending.
If we look back at the history of stocks in the aftermath of rate hikes, the S&P500 averages 13,3% return over a 1-year period after the final rise in borrowing costs.
Further evidence of this is shown by the Russell 1000 index which has also shown a positive return on average in the six months period after peak interest rates at an average of 11%. This is in comparison to an average return of 6.3% for all six months periods. Indicating additional positive returns compared to normal.
Summary
Market’s expectations is more dovish with most expecting one more hike of 0.25%.
Our house view is that the Fed does not need to hike anymore as the impact of the current record hiking cycle hasn’t even started to impact inflation and it’s already rolling over. That doesn’t mean they won’t but either way, we believe that we are at or near the top of the interest rate cycle and can expect significant rate cuts ahead. Importantly, we have positioned our client portfolios to ensure that when these cuts do happen, they will capture the upswing.
What is important is that whenever the peak has been reached, there is cause for optimism for investors.
