Faster Fed tightening is consistent with rising equities

The Federal Reserve raised rates for the first time since 2018, while top officials pointed to a faster pace of tightening ahead. The median forecast from members of the Federal Open Market Committee (FOMC) is now for seven rate hikes this year, and three more next year, which would take rates above a neutral position.

But while the meeting was more hawkish than expected, the S&P 500 closed 2.2% higher on Wednesday, the day of the decision. The upswing continued, with the index ending the week 6.2% higher. We don’t see this as inconsistent for the following reasons:

1. The Fed reestablished its inflation-fighting credentials (inflation expectations subsequently fell), and Powell asserted that the economy is strong enough to withstand higher rates.

• The dot plot now matches market expectations for 2022. Fed Chair Jerome Powell repeatedly stressed that the central bank was “determined” to ensure a return to price stability. Markets initially appeared to welcome the Fed's efforts to get ahead of the curve with the 5-year/5-year forward inflation swap, a market-based measure of longer-term inflation expectations, falling from 2.65% to 2.51% after the rate decision.
• The FOMC also emphasized that the economy was resilient and data had “continued to strengthen.” Powell described the labor market as “extremely tight.”

2. A flattening of yield curves is not a sign that markets expect an imminent recession.

• The bond market is pointing to slowing growth and rising recession risks, with the 5-year to 10-year part of the US Treasury yield curve briefly inverting. Markets are now looking for rate cuts in 2024. An inversion of the 2-year/10-year curve has preceded every recession in the last 70 years. While this curve has flattened to around 20 basis points, from around 90bps earlier in the year, it is still positive, and we expect it to steepen modestly.
• Historically, even when a recession did follow an inversion, there was a long and variable lag. Recessions started, on average, 21 months after an inversion, with a range of 9–34 months. Since 1965, the S&P 500 has returned an average of 8% in the 12 months following a 2-year/10-year inversion.

3. Equities often rally at the start of a rate hiking cycle.

• Typically, equity performance is positive in the early stages of a rate hiking cycle. Since 1983, the S&P 500 has returned an average of 5.3% in the six months following the first Fed rate rise of a cycle.
• The Fed’s goal remains to engineer a soft landing for the economy. With inflation close to 8% year-over-year, the Fed’s focus is understandably on price stability. But its main concern could shift back toward its maximum employment goal if inflation recedes, as we expect, and if the economy shows signs of weakening.

So, we advise investors to prepare for higher rates while remaining engaged with equity markets. We prefer a hedging strategy and selective equity exposure over exiting risk assets. In our view, energy stocks provide a hedge against risks arising from the war in Ukraine, while financials and value stocks tend to outperform in periods of rising rates.

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