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March 16, 2022

The Fed is about to hike rates. Here’s what history shows should happen to the stock market next

The Federal Reserve is set to raise interest rates for the first time since 2018 to rein in inflation, and here’s how the stock market could react to the move, if history is any guide.

The central bank is widely expected to raise its target fed funds rate by a quarter-percentage point from zero at the end of its two-day meeting Wednesday. The Fed will also release its new forecasts for rates, inflation and the economy, given the uncertainty from the escalated geopolitical tensions.

Here’s the bottom line: When the Fed embarks on a series of rate hikes in a row, the stock market still typically manages to go higher during that time, but the gains are harder to come by than normal times, or when the central bank is lowering rates.

It especially struggles in the short term, according to Sam Stovall, CFRA chief investment strategist, who studied market performance and the Fed’s moves going back to 1946.

The S&P 500 has edged up an average of 1.3% six months after the start of a rate-hiking cycle since 1946, compared to an average gain of 5.5% six months after a rate cut, according to the data.

The underperformance continues 12 months and 18 months later with the S&P 500′s returns significantly lagging the periods after an easing cycle begins, the data showed.

Perhaps it’s not too surprising that the market tends to underperform during a tightening cycle as contractionary monetary policy is intended to slow down overheated economic growth and curb surging price pressures. Boosting interest rates increases the cost of borrowing and could negatively impact growth-oriented company performance.

Tech stocks are seen as sensitive to rising rates because increased debt costs can hinder growth and can make their future cash flows appear less valuable. They have suffered a particularly severe sell-off recently with the Nasdaq Composite falling into bear market territory recently, or down more than 20% from its record high.

Will market struggle more this time?

Some investors believe history may not be the best guide this time around and the stock market could struggle even more because the Fed is not dealing with a typical economic upturn. Inflation is the highest in four decades, which could cause the central bank to act faster and bigger than is typical of past rate cycles.

“Investors need to recognize that this hiking cycle could in all probability look very different than recent ones, and its exact nature is still ill-defined,”  said Scott Ruesterholz, a portfolio manager at Insight Investment.

“Higher inflation could force the Fed to move even more quickly than our expected 5 hikes this year while additional growth shocks could mean the economy needs fewer hikes than currently expected to slow sufficiently to stifle inflation,” Ruesterholz added.

Inflation hit a fresh 40-year high of 7.9% in February. Notable investor Jeffrey Gundlach said he sees the likelihood for inflation to hit 10% this year, calling for more aggressive tightening than the market expects. Current pricing indicates the equivalent of seven total rate increases this year — or one at each meeting.

“To the extent that the Fed can continue down the path the market expects — deliberate rate hikes all year long — the areas that have held up since the stock market became unglued five months ago look set to continue functioning as havens,” said Jeff Weniger, Head of Equity Strategy for WisdomTree.

Weniger said opportunity lies in indexes that have lighter exposures to “trouble” groups such as consumer discretionary and speculative tech stocks.

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