With the US Federal Reserve (Fed) in the process of raising interest rates, however fitfully, investor concerns quickly turn to the outlook for equity markets. The conventional wisdom is that equity markets suffer when interest rates rise. This view is coloured in particular by the experience of 1994, when a series of steady rate hikes lead to poor market performance.
One episode is clearly not sufficient for an investment case, however. Taking into account all the periods of rising rates since the end of World War II offers more clarity. We can also investigate the performance of the economic sectors, as rising interest rates affect some business models more than others.
We have combined the old S&P industry indexes with the newer GICS versions to create a continuous series from 1945. We have then identified 19 episodes of rising interest rates and calculated the return of the sectors relative to the S&P 500. The results are shown in the table below.
Exhibit 1: Sector return relative to S&P 500 since 1945 in year following first hike
The first thing to note is that the S&P 500 actually posted positive returns in the year following the first interest rate hake most of the time, showing a 53% 'hit rate'. The average, inflation-adjusted return was 1.8%. Two factors that influenced whether equities were able to rise in the face of higher rates were the level of inflation and the pace of the hikes. When inflation was relatively high and the Fed was hiking rates in order to bring it down, the S&P generally (though not always) declined. Periods when the degree of interest rate hikes was modest (less than 200 basis points), also corresponded to rising markets, though in 1958 and 1978 the Fed hiked nearly 300bp and the S&P nonetheless rose.
Every period is unique and one cannot draw direct conclusions from history, but the environment today is more analogous to the low-inflation, slow-hike episodes of the past, suggesting that the Fed’s policy alone is unlikely to drive equity markets lower. Other factors, might however.
A few of the economic sectors of the S&P 500 showed more predictable behaviour during a rising rate cycle. The two sectors which generally outperformed the S&P 500 were technology (63% of the time with an average relative return of 5.4%), and industrials, which outperformed 74% though the average return was -1.6%. Of the two, technology is probably the more attractive in the current environment thanks to the dynamism of the sector and the need for companies to invest in technology in order to reduce costs. With the manufacturing sector, both in the US and elsewhere, still weak, industrials may not see the improvement in earnings they have in the past. Health care beat the S&P only a bit more than average, 58% of the time, but it still showed a positive average outperformance relative to the S&P. We believe the sector remains attractive today, though the driver of corporate profit growth is the restructuring following the Affordable Care Act.
Consistent underperformers were utilities and financials, which managed to beat the S&P in only 26% and 32% of the time, respectively. Caution about both these sectors is probably warranted today. Thanks to investors hunting for yield, the multiple on the S&P utilities sector is 30% above its long run average. The financial sector faces ongoing regulatory challenges and chronically low interest rates crimping profitability.
Besides the performance of the S&P 500, the behaviour of the US dollar is also of interest, particularly given the dramatic swings in its value since the beginning of the global financial crisis. The nominal, trade-weighted value of the dollar on average rose when the Fed was hiking rates, though only barely, just 57% of the time. It was more likely to rise when the Fed hiked 175 basis points or more, and to fall when it was less. Given expectations for perhaps just another 50 bps between now and the end of the year, it is not certain the dollar will strengthen. What is of course different this time is the currency-weakening policies of the European Central Bank and the Bank of Japan. Though they make up about a quarter of the index, it could be enough to prompt a rise in the dollar nonetheless.
With bond yields very low and the Fed moving ahead with its plans to tighten monetary policy, albeit slowly, equities still appear to be the relatively more attractive asset class. Focusing on the sectors which have proved more resilient in the past to higher financing costs, however, should offer an extra boost to potential equity market returns.