How markets perform during tightening cycles

Market reaction to rate rises

Developments in China and in the oil price have dominated the headlines so far this year, but some attribute the increase in market volatility to the decision by the US Federal Reserve (Fed) to raise interest rates back in December (which is also known as tightening monetary policy).

History shows us that in fact, equity markets generally perform very well when the Fed is raising interest rates.

Looking at the last 13 tightening cycles, the chart below shows that the S&P 500 has risen in value over the 24 months leading up to, and the 24 months following, the first rate hike in the tightening cycle. 

Figure 1: S&P 500 performance in hiking cycles

NB: Previous starts to hiking cycles include: Jun ‘55, Aug ‘58, Aug ‘63, Dec ‘68, Mar ‘72, Aug ‘77, Oct ‘80, May ‘83, Dec ‘86, Mar ‘88, Feb ‘94, Jun ‘99, Jun ‘04

However, this time may be different. The S&P’s rise in these periods was driven entirely by higher corporate earnings (see the second chart in Figure 1).

Usually the Fed’s tightening of monetary policy is an indication of a growing economy, which translates into greater demand for companies’ goods and services, and thus better revenue and earnings growth.

However, equities tend to de-rate (i.e. experience a fall in valuation) when the Fed raises interest rates, largely in response to the bond market selloff that usually accompanies such a move.

That is why the third chart above shows that the price-earnings ratio usually declines in tightening cycles.

However, stronger earnings growth has tended to outweigh the negative effect of the de-rating in past cycles and result in share price gains overall.

How similar are things this time around?

The question is whether we can expect the present tightening cycle to have a similar effect on markets today.

The difference is that the Fed is raising rates at a later point in the economic cycle than it has in the past and corporate profits appear to have already peaked.

The case for a further improvement in earnings may therefore not be as strong as in previous hiking cycles, especially with an increase in wages still expected to come through.

The concern therefore is that if the Fed’s rate rise results in a de-rating of the market, and earnings growth isn’t strong enough to offset the de-rating, the market will come under pressure.

So should we be more bearish about equities overall if the US market is going to struggle somewhat?

Although the US earnings outlook is challenging, there are still some supportive trends for the market.

For example, US companies are generally cash-rich which should provide them with plenty of options for future growth, including through mergers and acquisitions (M&A), as well as the potential for share buybacks.

Outside of the US, other equity markets offer more appealing earnings prospects though, in our view.

At this point, Europe and Japan are better placed to deliver higher earnings as the economic cycle in both economies is at an earlier stage and their central banks are still focused on keeping monetary policy loose to support growth.  

Markets have hit the panic button

While seeking areas with the best earnings prospects seems like a sensible strategy, many investors would still rather sit out the current volatility in the equity market.

For example,  the Credit Suisse risk appetite index, which was devised to measure changes in investor sentiment using a combination of asset returns and volatility,  is now well into “panic” mode (see Figure 2 below).

Safe assets have outpaced risky by a significant margin. However, past evidence suggests this can be a good time to buy equities.

As you can see in figure 3 below, markets generally rise after entering panic mode.

Figure 3 shows the total return of the S&P 500 12 months after the Credit Suisse risk appetite index began to indicate panic.

The one exception to this was during the last financial crisis period when the index went into panic territory for around a month from March 2008.

The indicator then rotated back into panic later in the year when there was a big spike in volatility in the aftermath of the bankruptcy of Lehman Brothers. 

Figure 2: Credit Suisse risk appetite index hits panic

Figure 3: Performance of S&P after entering panic

Overall, this Credit Suisse Risk Appetite index tends to be a useful contrarian indicator of when investors’ sentiment hits extremes and the market is looking oversold.

Looking for a catalyst

While this could be a sign that now is a good time to buy equities, we hold a neutral view on the asset class overall.

The slowdown in the earnings cycle in the US means we are no longer as positive on this area of the market as we were in early 2015.

Although we are constructive on Europe, this is outweighed by a negative outlook for emerging markets, given the continued weak cyclical environment and detrimental effect of the Fed’s interest rate hike on these economies. 

In the near term, we need to see some stability in the Chinese yuan and in the oil price for the outlook for equities to improve.

Signs that the Fed is backing away from another rate hike in March would also help and Janet Yellen’s Testimony to Congress next week will be critical in this respect.

Further ahead though, the focus will be on earnings growth, which our analysis shows drives markets during these periods.