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Last week’s news that inflation eased more than expected in October reinforced the view that the Federal Reserve is ready with its most aggressive rate hike campaign in four decades.
And that could be a boon for the stock market and your 401(k).
According to an analysis by Ryan Detrick, chief market strategist at Carson Group, the S&P 500 index rose an average of 14.3% in the 12 months after the Fed’s last rate hike over the last 10 rate hike cycles dating back to 1974.
By comparison, the index’s average return through 2022 is 7.5% over five years, 10.4% over 10 years, 7.5% over 30 years and 10% over the past century, according to NerdWallet.
Investors are very pleased when the central bank no longer hits them with interest rate increases.
What happens if the Fed raises rates?
Interest rate hikes drive up the costs of mortgages, auto loans, credit card purchases and other borrowings, dampening economic activity and hurting corporate profits, Detrick notes. They also make stocks relatively less attractive than bonds, which carry less risk for now rising returns.
Of course, the pain is ostensibly for a good purpose: reducing inflation, which could become entrenched and, at least according to the Fed, do even more damage.
Stopping interest rate hikes does the opposite, improving the economic outlook and making stocks more attractive than bonds. It also removes a big cloud of uncertainty from the market, said Adam Turnquist, chief technical strategist at LPL Financial.
Is the stock market recovering?
From the day the Fed started raising rates in March 2022 through last Monday, the S&P 500 saw some wild swings, eventually settling at 4,411. But since the Department of Labor released the favorable Consumer Price Index report early Tuesday, the benchmark stock index has risen more than 100 points, or 2.3%.
“If July was the last rise, which we believe was the case, stocks historically do quite well a year after that last rise,” Detrick says.
LPL Financial’s Turnquist called it a “catalyst for the stock market.”
There are some caveats.
First, Fed officials have said they have not ruled out further rate hikes even after the encouraging inflation report, although most economists have done so.
What impact will an interest rate pause have on the market?
And while the end of rate hikes produced double-digit market gains in eight of the 10 rate hike cycles over the past half-century, the S&P 500 suffered steep 12-month losses in two of those periods. The halt to interest rate increases in July 1981 failed to prevent a 16.4% market decline, amid a brutal recession fueled by interest rates that were still in nosebleed territory at levels above 17%.
Similarly, omitting the June 2000 interest rate hikes did not prevent the 2001 dot-com recession.
“The (dot-com) bubble had burst, limiting the impact of a pause and subsequent rate cuts,” Turnquist said.
At the other end of the spectrum, in 1995, the Fed’s decision to end large rate hikes and then cut rates likely helped push market returns to 35% the year after the last rate hike. But so did a robust economy fueled by software-based productivity gains.
In other words, during most of the Fed’s previous decisions to hold, the Fed has been a “key driver” of strong market gains, Turnquist says. But sometimes other forces were at play.
Such dynamics could impact stocks and your 401(k) in the coming months.
What happens in an earnings recession?
In the third quarter, for example, S&P 500 companies appear to have emerged from a year-long earnings recession (characterized by declining quarterly profits), according to recent earnings reports. That could undermine the market.
That includes a continuation of recent strong productivity gains, further fueled by artificial intelligence, which could allow employers to raise wages without raising prices, Detrick says.
Are shares currently too expensive?
At the same time, stocks are relatively expensive: 18.6 times estimated earnings over the next 12 months, above the 10-year average of 17.6, according to Turnquist and FactSet. That puts more pressure on the economy and profits to perform well, Turnquist says. If the US is hit by a moderate or severe recession, it could ravage the market regardless of what the Fed does or doesn’t do.
Another thing to keep in mind: The solid market gains following the Fed’s decision to halt rate hikes may also have been boosted by subsequent rate cuts. In December 2018, the Fed raised rates for the last time, contributing to market gains of 11.7% and 17.7% in the following three and six months, respectively.
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But in August 2019, Fed officials began cutting rates, pushing S&P yields to 27.9% in the 12 months after the last rate hike.
Over the medium term, a Fed that stays on the sidelines could continue to boost stock markets. But investors expect rate cuts by May or possibly even sooner, futures markets show.
If the Fed pushes back against that narrative and continues to embrace the “higher for longer” mantra, “stocks could pull back and give up some of this recovery,” Turnquist says.