Next week on Wall Street: The Fed’s latest rate hike tends to benefit stocks, but this time some have doubts
Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., August 15, 2023. REUTERS/Brendan McDermid/File Photo Acquire License Rights
NEW YORK, Sept 15 (Reuters) – The end of the Federal Reserve’s interest rate hike cycle has generally been a good time to own U.S. stocks, but an uncertain economic outlook and stretched valuations could dampen the upside this time.
After raising borrowing costs by 525 basis points since March 2022, the Federal Reserve is widely expected to leave interest rates unchanged at the conclusion of its meeting next week. Many investors believe policymakers are unlikely to raise interest rates even further, which would end the central bank’s most aggressive monetary tightening cycle in decades.
If they’re right, shares could post further gains. After the last six periods of Fed credit tightening, the S&P 500 (.SPX) rose an average of 13% from the last rate hike to the first cut in the following cycle, an analysis by financial research firm CFRA showed.
However, investors with a more pessimistic outlook say it is only a matter of time before higher interest rates worsen the economy and trigger a downturn. The S&P 500 is already up over 16% this year, thanks in part to a U.S. economy that has proven resilient in the face of higher interest rates.
“The market will probably welcome it a little bit when the Fed’s rate hike cycle ends,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management Company.
“However, I don’t think the economy will escape a recession and that will ultimately determine the direction of stocks,” said Schutte, whose company favors fixed income over stocks.
Although most investors believe a recession is unlikely in 2023, for some market participants a slowdown next year remains. A worrying recession signal has been the inverted Treasury yield curve, a market phenomenon that preceded past downturns.
According to the CME FedWatch tool, which tracks bets on futures tied to the central bank’s key interest rate, the probability of it leaving rates unchanged is 97%. Traders expect the Fed to leave interest rates on hold in November at about a two-in-three chance, CME data showed.
The odds for December show that the probability of interest rates remaining at current levels is around 60%.
The line chart using data from LSEG Datastream shows the Federal Funds Rate, PCE Inflation and Core PCE Inflation in the US.
Top prices?
Fed Chairman Jerome Powell said last month that the central bank may need to raise interest rates further to cool inflation and vowed to tread cautiously at upcoming meetings.
But more broadly benign inflation data in recent months could mean the Fed’s quarter-point hike in July was the latest in a cycle that rattled asset prices last year.
“If Wall Street concludes that the Fed has ended its rate-hiking program, that would at least give stocks support, if not an additional catalyst, to continue rising,” said Sam Stovall, chief investment strategist at CFRA.
Investors are also trying to gauge when the Fed will begin easing monetary policy. CFRA found that the Fed cut rates an average of nine months after its last hike, with the S&P 500 gaining an average of 6.5% in the six months following the cut.
Investors are already anticipating a low probability of a rate cut at the Fed’s January meeting and are expecting a cut of about 35% in May, according to CME data.
However, some investors see challenges for the stock market even after the Fed finishes raising interest rates.
Analysts at Oxford Economics predict further decline in global earnings, pointing out that stocks “typically delivered far weaker returns following the Fed’s last rate hike, when it coincided with an EPS decline.”
Oxford and other investors are also concerned about stock valuations, which have risen sharply this year. According to LSEG Datastream, the S&P 500 trades at about 19 times forward 12-month earnings estimates, compared to 17 times at the start of the year and its long-term average of 15.6.
Stock valuations are also at risk from the rise in bond yields, which has increased the attractiveness of fixed income securities as an investment alternative to stocks. The 10-year Treasury yield is near a 15-year peak.
“If (the Fed) came out and said, ‘We’re done,’ I think that’s probably cause for celebration,” said Jack Ablin, chief investment officer at Cresset Capital. “But I’m not sure how sustainable it would be if stocks were already valued relative to bonds.”
Reporting by Lewis Krauskopf; Edited by Ira Iosebashvili and Richard Chang
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