Should we fret about Fed rate hikes?
No, we shouldn't.
It has been a long time since we last seriously contemplated rate hikes – we have not actually seen one from the Fed since June, 2006 – but the same was said going into 1994 since back then the prior hike was in 1989, and again heading into 2004 because the last hike was in 2000.
In these balance sheet recessions, it is not rare to go five years between rate cycles.
This time around it will have been more than nine years, so we are long overdue – and I am wary that the Fed may overstay its welcome on the uber-accommodative phase as it did in 1993 and 2003 when, in hindsight, it is obvious that they were at least a full year behind the curve.
The history books show that at no time did a bull market end after the first rate hike.
Typically – in terms of trough to peak moves in the S&P 500 – we are only one-third of the way into the bull run on the eve of the first Fed tightening in rates. That is an average, but the median is almost identical and there was never a time when the cycle was more than halfway through at that point of the first rate increase.
It could be different this time given the magnitude and duration of this cyclical surge – the Fed has never (at least back to the 1950s) waited as long as five years into a bull market to begin to raise rates – the range is usually one to three years (even following the tech wreck).
Even so, the peak in the market is usually a good three years after that initial Fed volley – the shortest lag was in the late 1960s at a year-and-a-half.
Not only that, but the historical record shows that only when we are deep into the Fed rate-raising cycle does the stock market begin to peak out and roll over – in terms of magnitude, not just duration.
The average increase in the Fed funds rate is 350 basis points (and the median 220 basis points) from the lows before the S&P 500 finally begins to succumb to the liquidity squeeze, and since 1960 the smallest run-up that induced a bear market was 130 basis points.
I always say that we should let the yield curve do the talking and at the historical peaks in the S&P 500, both on a median and average basis, the gap between 10-year U.S. Treasury note yields and two-year comparables is less than 50 basis points – today that curve is more than 140 basis points.
Wake us up when the war begins.
So at some point, yes, Fed rate hikes will cause a market setback, but that is usually in the mature stages of the tightening cycle as the yield curve flattens – which means the market won't have to deal with it until it starts to price in the growth implications of that flatter curve.
That does not mean that sector rotation won't be important – in fact, it will be key.
For the time being, the prudent way to go in my opinion is a diversified portfolio that focuses on what works in a rising bond yield, steep yield curve and inflationary environment.
Something else to consider is what the historical record says about equity sector rotation from the time leading up to that inevitable first rate hike and thereafter.
In that pre-rate-hike time frame, the leaders are financials, tech, industrials and consumer discretionary while the laggards were typically health care, consumer staples, utilities and telecom services – so cyclicals over defensives and within rate-sensitives look for those sectors with more torque and yield curve sensitivity.
From the time the Fed begins to tighten to the peak in the S&P 500, the relative performance shifts: Energy, materials, consumer staples and health care outperform (these are late-cycle inflation segments and defensive growth areas); consumer cyclicals, tech and financials give up leadership.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.