OCEAN CITY — As investors focus on when the Federal Reserve (Fed) will start to raise interest rates, many remain concerned about the impact that a policy rate-hiking cycle may have on economies and markets. History suggests that rising rates need not be a major roadblock to economic and market progress, as rate-hiking cycles typically do not end in recession and instead lead to moderately slower economic growth and ease economic constraints.
However, using history as the sole indicator of how markets will react to the next rate-hiking cycle may not be wise, as the amount of monetary easing this time around has far surpassed past instances of it. In our view, both looking at multiple past rate-hiking cycles and focusing on the increments (how much), timing (when) and pace (how often) of the rate hikes is much more helpful.
We believe the Fed will remain patient and adopt a long and slow hiking cycle in response to improving U.S. economic data — possibly taking its time before making the initial hike and choosing not to hike at certain meetings once it has done it, similar to the rate-hiking cycles seen throughout the 1980s.
Importantly, the market has already priced in an extremely gradual hiking cycle, similar to staircase-like cycles in the past Historically, U.S. equities have tended to fall modestly in the run-up to the first Fed rate hike and to recover initial losses over the subsequent 12 months. However, returns over those 12 months vary significantly by sector.
BofAML Chief Equity Technical Strategist Stephen Suttmeier has highlighted a few trends in sector performance following the initial rate hike.
Cyclical sectors, like Energy and Technology, are dependent on a strong economic environment. As interest rates rise, the Fed signals that the economic outlook looks stable and, given a durable economic backdrop, these sectors tend to perform well. On the other hand, more defensive sectors, like Telecom, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs), tend to underperform due to their business cycle sensitivity to higher interest rates. On average, in the 12 months following an initial Fed hike, the sectors with the strongest returns are Energy, Technology and Health Care.
The weakest-performing sectors, on average, over the 12 months following an initial Fed hike are Banks, Financials, Telecom, Consumer Discretionary, Consumer Staples and
Industrials. Sector performance over shorter time periods can show large price swings.
While using history as an indicator of how broad markets or specific sectors will perform in the current environment appears convenient, we caution that select sectors (Energy, most notably) face challenges that they didn’t face in previous rate-hiking cycles. In particular, investors should review their current allocations and make sure they are in line with strategic allocations. Investors also should refrain from changing their investment strategy based on history, as the future may not mirror the past.
In a rising rate environment, fixed income is consistently inconsistent. While rising rates negatively impact bond prices, that doesn’t necessarily mean negative total returns for all fixed income investments. Various fixed income asset classes respond differently, and a diversified income portfolio can help mitigate the impact on total returns. In our view, the questions investors should focus on are how fast rates are likely to rise, and what the magnitude of each rate
hike will be.
How the Fed raises rates is just as important as the direction of rates. The BofAML U.S. Economics team believes the pace of Fed rate hikes will be gradual. The instrument that the Fed will use to raise rates is likely to be the federal funds rate, a key tool in implementing policy decisions. Historically, the fed funds rate has been used to temper inflation as the economy grows. While inflation has not materialized in this cycle, other indicators, such as employment, are improving strongly enough to support a Fed rate hike. The Fed is likely to use the fed funds rate to raise rates, which will directly impact short-term rates. However, an increase in short-term rates does not directly cause long-term rates to increase as well. We believe long-term rates will likely remain anchored as demand for U.S. Treasuries is steady given low yields outside of the U.S.
The speed at which the Fed raises rates is important, given that, if it raises rates gradually, over a prolonged time period, the income on an investment can offset the decline in its price. More dramatic increases make it more difficult for the income to offset the decline in price. The BofAML U.S. Economics team believes the fed funds rate increases will be small in magnitude and likely to occur at every other meeting.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)