As the recovery moves along at a rate that no one in the government could have expected, preparations for an exit strategy are likely well in place inside the Federal Reserve – at least, we’d like to think so. History shows us that the first few months surrounding a rate hike are not the best in terms of stock market performance. Higher rates naturally leads to concerns about future equity returns and results in some risk aversion. This fear of rate digestion soon turns to euphoria, however, and stocks pick up momentum as duration from the rate hike increases. Like much of Fed policy, however, the Fed tends to be late to the game. They tighten too late into the game and cut too late. Luckily, by the time they begin to cut it is likely that the recovery train will be approaching full speed and after a few bumps in the road we can expect some pretty solid stock market returns:
Historical lessons when Fed starts to tighten. Our collective challenge will be to identify the start of tightening. But let’s keep it simple and focus on the first Fed rate hike, which normally flags the tightening phase. Note that Israel has already tightened, and Australia and Norway may tightenbefore year-end, too. The lessons from MSCI Europe performance around the first Fed rate hike are the following:
- Equity performance from 12 months prior up to 1-3 months prior to the first Fed rate hike are strong. Returns have been positive in 7 of 7 cycles since 1977 with average returns of 17% during the 12 months prior to the first Fed rate hike.
- The first hike typically leads to some indigestion with performance slowing ahead of the first Fed rate hike, and subsequent 3-month returns negative on average. The odds are also more mixed further out: subsequent 12-month returns averaged 10.4% with the market up in 57% of cases.
Source: MS Research
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.