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May 22, 2023
Weekly Market Update | May 22, 2023
John Lynch, Chief Investment Officer
Weekly Market Update:
Last Fed Rate Hike? History Not Supportive for Equities.
John Lynch, Chief Investment Officer
Comerica Wealth Management
Executive Summary
We believe monetary policy is now restrictive with the Fed Funds rate upper band at 5.25%, exceeding the 10-year Treasury yield of approximately 3.70%. If the Federal Reserve is indeed finished with its interest rate tightening campaign, history shows the equity market tends to struggle before the next easing cycle begins.
Key Takeaways:
- Pressure on the financial system due to banking stress, higher interest rates, and moderating inflation, suggest a terminal high point for the Fed Funds rate this cycle.
- The U.S. Treasury Yield curve typically steepens after the last Fed rate hike and prior to a recession, a trend evident over the past several weeks.
- Historically, performance for the S&P 500® Index shows significant market weakness following the last rate hike when the economy is heading into a recession.
- Pause or Pivot? The outcome for equities varies significantly under the two scenarios. Bonds, on the other hand, tend to fair well under both scenarios, supporting the case for diversified strategies on long-term portfolios.
Restrictive Policy = Volatile Markets
Over the past 14 months, the Fed has endeavored to combat inflation by relentlessly increasing the Fed Funds rate. Monetary policy is now restrictive with the Fed Funds rate upper band at 5.25%, exceeding the 10-year Treasury yield of approximately 3.70%. Considering stress in the banking system and indications that inflation has peaked suggest the likelihood that we have reached a terminal high point for the Fed Funds rate this cycle.
What does this imply for the financial markets?
Historically, if there is no recession, the period between the last Fed Funds rate hike and the first cut has clocked reasonable performance. For example, the periods following Fed hikes around 1984 and 1989 showed limited market disruption, while the market effectively bottomed on the last Fed hike in 1995. However, during the instances when a recession ensued, market performance was significantly weaker. The explanation lies in the lagged effect of monetary policy on the economy, with the timing of recession often at odds with the Fed’s estimates, and the concomitant decline in earnings, by the time monetary officials stop raising rates. See chart: S&P 500® Performance Following the End of Fed Rate Hike Cycles.
Following the last hike, investors then tend to price in the next step in the cycle, Fed easing, with an average firming of approximately 7.1% in the index between the last hike and first cut. However, market lows are typically not reached until after the Fed easing cycle begins. Since 1980, the S&P 500® on average has bottomed out 293 days after the last rate hike, with an average decline of 21.4%.
Recession Likely
Comerica Bank Chief Economist Bill Adams projects that the economy will contract in the current quarter through year-end, which may portend a recession.
History shows that the U.S. Treasury Yield Curve, after a period of intense flattening/inversion, begins to steepen just prior to the onset of recession. Additionally, the chart below shows the typical steepening of the yield curve (10-year vs. 2-year Treasury yields) often coincides with the last Fed rate hike and prior to recession. We have already begun to see this trend in recent weeks. See chart: U.S. Treasury Yield Curve and Recessions.
Performance for the S&P 500® Index also shows significant weakness following the last rate hike when the economy is heading into a recession. If historical precedent ensues, the last Fed rate hike for this cycle does not bode well for equities in the near-term. See chart: S&P 500® Index and Recessions.
Fed Pause or Fed Pivot?
Assuming Fed Funds have reached the terminal rate for this cycle, the key question is: will the Fed pause or pivot? A pause would maintain the current Fed Funds level as is for longer than six months in a continuing effort to subdue intractable inflation. A pivot would revert to a lowering of the Fed Funds rate within six months to bolster growth and support the financial system. Data since 1950 suggests the outcome for equities varies significantly under the two scenarios. Bonds, on the other hand, fair well under both scenarios. See chart: Treasuries vs. Equities.
Conclusion
On the surface, the equity markets have remained resilient this year in the face of a deteriorating earnings outlook, though valuations remain high, and sentiment appears complacent. Given our expectation for contracting economic activity, equities remain vulnerable as we continue to expect a retest of the October lows. While market performance is highly dependent on Fed action, pause or pivot, diversification remains key as bonds historically offer ballast for long-term portfolios.
Be well and stay safe!
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Contributors
John Lynch
Chief Investment Officer
Comerica Wealth Management
Deborah Koplik
Director Portfolio Management
Comerica Wealth Management
Matthew Anderson
Senior Analyst
Comerica Wealth Management
May 22, 2023
