What next for equities when US rates peak?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

• Investors have become increasingly confident that the US economy might avoid a recession in the near term, though one still looks likely. That has helped equities to perform well, as inflation also eases in most major economies and hopes grow that US interest rates will peak soon  
• Analysis of how equity markets behave around the peak of an interest rate hiking cycle since the 1970s, and ahead of a recession, could help to show where equity markets might head next. In general, recessions follow around eight months after the last rate hike (of a cycle), and then end thirteen months after the initial rate cut  
• Turning to equity markets, global shares have averaged a 7% annual gain in the year after the last increase in policy rates in hiking cycles. In addition, the most defensive parts of the market, such as healthcare and telecoms, generally outperform in the months following the peak in rates (albeit this doesn’t guarantee future performance) 
• Given the level of economic uncertainty and buoyant equity market valuations, a defensive positioning in portfolios appears warranted. Being more selective in choice of equities while staying diversified also seems called for

Equity markets have maintained their recent gains over the summer, as the outlook for growth and inflation globally has improved and hopes of a ‘soft’ landing for the economy have gathered pace. Inflation has eased more quickly than expected in many major economies, while global growth has remained resilient, aiding sentiment. 

While interest rates are probably close to their peak, they are likely to remain elevated for an extended period of time. 

This article explores how equity markets have behaved following the end of US monetary policy tightening cycles in the past 50 years. Given expectations of a mild and short-lived recession at some point in the coming months, the analysis focuses on US hiking cycles around recessions only, which excludes the August 1984 and February 1995 peaks in rates. This identifies seven episodes, with peak rates observed in April 1974, March 1980, May 1981, February 1989, May 2000, June 2006 and December 2018 (see table).

US interest rate hiking cycles around recessions in the past 50 years 

Length of the pause in rates between the last hike and the first cut by the US Federal Reserve, and the timing of the recessions around the last hike

Equity market performance following peak rates

Based on those episodes and following the last hike, the US Federal Reserve (Fed) left rates on hold for five to six months on average before cutting rates. The length of the 'pauses' varied substantially (between one and 15 months), with the shortest 'pauses' coinciding with periods of sharp deterioration in economic activity (April to July 1974, March to April 1980 and May to July 1981).

A recession materialised eight months on average after the last Fed rate hike, and ended 13 months after the first cut. The central bank generally reduced rates two months before the onset of the recession, with rates then bottoming six months after the end of the recession. The rate-cutting cycle lasted for 24 months on average. 

The analysis shows that on average, following the last hike, developed market equities flatlined for about five to six months, while rates were on hold, and grinded higher in the subsequent months, after the first cut.  

The MSCI World index returned 7% on average in the year following the last US rate hike, including dividends, and 4% in the subsequent year. This compares with average annual returns of 11% for the MSCI World index over the past 50 years (see chart) – albeit past performance is never a guarantee of future performance.

MSCI World equities have delivered positive returns on average in the two years following the last Fed rate hike, but within a wide range

MSCI World total returns (including dividends) in the 12 months before, and the 24 months after, the last Fed rate hike of a cycle in the past 50 years

However, as shown in the next chart, those averages mask a very wide dispersion of returns across the various cycles. Six months after the last cut, total returns for the MSCI World Index varied between -29% in 1974 and +19% in 2019. Twelve months after the last cut, they ranged between -5% and +29%.

Wide dispersion of equity returns around each of the last Fed rate hike in a cycle, followed by a recession, in the past 50 years

MSCI World total returns (including dividends) in the 12 months before, and the 24 months after, the last Fed rate hike in the cycle, over the last 50 years

Looking at the parts of the equity market that performed best, the most defensive areas of the market generally outperformed in the months following the peak in rates, which is not surprising given that the economy was slowing or contracting. 

US equity returns generally outpaced those elsewhere, while defensive sectors outperformed the cyclical ones. That being said, the extent of this outperformance was relatively limited. 

The more defensive parts of the equity market have tended to outperform in the months following the last Fed rate hike of a cycle

Average relative total returns of non-US equities vs US equities, and developed market cyclical sectors vs defensive sectors in the 12 months before and after the last Fed rate hike of a cycle 

Macroeconomic and market environment

While the recent easing of inflationary pressures globally suggests that the Fed and other major central banks will probably stop hiking rates soon, it seems premature to expect rate cuts this year. History shows that central banks can leave rates 'on hold' for a long time, depending on how the economy responds to the policy tightening. 

The difficulty for policymakers is that monetary policy transmission mechanisms work with long and variable lags. Indeed, the full effect of the aggressive hiking cycle of the past 18 months is yet to be seen. 

Those effects will be compounded by the recent tightening in bank lending standards, which has already led to a significant decline in loan growth, and will contribute to a further slowdown in economic activity. Even if rates are close to their peak in major economies, the key question is how long they will stay elevated. If left 'on hold' in restrictive territory for too long, those rates could precipitate the next recession.  

While the growth/inflation mix has improved over the summer, a shallow recession this year or next appears most likely. The risk of an imminent recession may have diminished, but it has not disappeared. 

In spite of all this uncertainty, equity markets have rallied strongly from their October lows. Valuations look stretched and out-of-sync with macroeconomic fundamentals. Investor sentiment is no longer the tailwind it was for markets back in October, when it was deeply depressed. It has improved substantially in recent weeks and is now bullish by historical standards, according to the American Association of Individual Investors’ survey¹.  

This does not leave much room for disappointment, as we saw in July and August during the US second-quarter earnings season. Earnings turned out to be better than generally feared, but share prices reacted more negatively than usual in subsequent days, both for positive and negative earnings surprises. 

While some of this may be attributed to more conservative management guidance for the coming quarters, it also seems to reflect overly optimistic earnings expectations from investors, that were built into the share prices. In contrast, analysts had significantly reduced their earnings forecasts ahead of the reporting season, setting a low bar for companies to 'beat' consensus expectations. 

Investment implications

While the narrative has shifted to a soft landing of the economy, equity markets seem to be discounting an even more optimistic scenario. Recent market moves appear consistent with a reacceleration of economic activity and high single-digit growth in global earnings this year. In contrast, analysts expect flat earnings, while bank lending standards suggest possible declines.  

As the analysis shows, the performance of equity markets in the months following the last hike (of a cycle) has varied substantially, from very positive to very negative. Therefore, it does not provide much guidance for future returns.

Given the level of economic uncertainty, stretched valuations and bullish investor sentiment, a defensive positioning in portfolios appears warranted, similar to the message expressed in our Mid-year Outlook 2023. 

In the current environment, capital preservation and yield enhancement strategies should be to the fore, as opposed to those aimed at capital appreciation. Given the relatively attractive yields on offer at present, fixed income markets appear more attractive. With uncertainty in markets heightened, investors might consider diversifying their holdings across traditional and alternative asset classes. 

Within equity portfolios, they should be more selective and opportunistic at the stock level, but stay diversified across sectors, factors and geographies. With most indices looking stretched against macro fundamentals, the bulk of the opportunities in the near term lies at the stock level, in our opinion.  

As more clarity emerges on the outlook for the economy this year, the market will likely become more discriminating when it comes to company fundamentals and valuations. In other words, we should see a return to a stock picker’s market, where idiosyncratic risk defines market performance (as opposed to common macro factors). This type of environment favours actively-managed strategies versus those that invest passively and track indices.