A year into its fight against inflation, the Federal Reserve could — just maybe — be done raising its policy rate. History shows that monetary policy pauses mark great buying opportunities for US stocks, but there are several key caveats to bear in mind this time.
In post-pause data going back to the early 1980s, the S&P 500 Index has posted an average return of 6.9% after three months; 18.9% after a year; and 34.7% after two years. That’s much better than the index’s 11.1% compound annual return over the past four decades and indicates why investors may be inclined to maintain equity exposure despite recent banking sector jitters. Even in 2006, stocks still had another 15 good months of upside after the Fed pressed pause and some 27 months total before Lehman Brothers collapsed. Eventually, the Fed tends to break something, but it typically takes a while.
Now, investors find themselves staring down another set of tough decisions. Last week, Fed policymakers raised the fed funds target range by 25 basis points to 4.75% to 5% in what was widely interpreted as a “dovish hike.” Fed Chair Jerome Powell paired the rate increase with a new emphasis on the risks to the US economy as the banking turmoil looked poised to curb credit availability to an unpredictable extent. With that, Powell and his colleagues introduced the possibility that we’ve seen the final increase of the cycle. Even if March wasn’t the peak, market pricing and policymaker projections suggest it’s probably around the corner.
So should you play the averages and buy stocks? It’s complicated.
First, consider the most obvious driver of strong returns at the end of a significant hiking cycle: the prospect of declining risk-free rates. When the Fed pauses, declining Treasury yields generally inflate price-earnings ratios. This happens for theoretical reasons (analysts incorporate lower risk-free rates into valuation models, which increase the present value of future cash flows) as well as practical ones (stocks suddenly have an easier time competing for attention against lower-yielding fixed-income securities, driving flows.) Even in the dot-com bust, falling risk-free rates were enough to at least offset rising equity risk premiums for a while, effectively sustaining P/Es for months and forestalling the eventual crash. In short, if you believe that the sovereign debt rally has more room to run, then you may have a decent bull case for stocks.
But that’s a big “if.” Unlike most other recent hiking cycles, this would-be pause comes against a backdrop of rare high inflation. The last time the Fed paused amid such concerning core PCE numbers was 1989 — then as now, the index was up 4.7% year-over-year — and there’s only one other example of a pause with the policy rate being so low on a real basis (2018). So even if the pause has arrived, policymakers might have to stay at this level for the foreseeable future to ensure that they don’t drop the ball on their inflation mandate. It’s hard to get excited about the end of the hiking cycle if cuts don’t follow soon afterward.
Even if the optimists are right — if inflation suddenly recedes without a recession — there’s also the question of market timing to consider. Unlike previous cycles, traders have gotten way out in front of the Fed pivot. Two-year notes yield 127 basis points less than the fed funds rate (upper bound), and 10-year notes yield 163 basis points less. That’s unprecedented in the sample data and shows why there might not be much near-term juice left in the rally.
From an equity standpoint, this means that October may have been the time to make some quick returns on the basis of declining risk-free rates and rebounding P/E ratios. That’s when yields on the 10-year note peaked, and the S&P 500 traded below 3,600.
Next, there’s the question of earnings. According to historical earnings per share data from Yale University economist Robert Shiller, there’s never been another time when the economy was already in an earnings recession and the Fed was still in the midst of a significant hiking campaign. Typically there’s some latency between the pause and the decline in earnings. Ideally, the Fed finishes its campaign when companies still have something left in the tank, and EPS growth tends to marry beautifully for a time with the margin expansion discussed above. That seems to be the special sauce behind post-pause returns in a typical economy.
But this isn’t a traditional cycle, and the S&P 500 is already in an earnings recession that some strategists expect to deepen further. With the flood of government stimulus and unusual shift in consumption habits during the Covid-19 pandemic, many companies posted unsustainably strong earnings, and recent quarters were always going to appear weak by comparison. Add to that the blow of the Fed’s unprecedentedly fast policy tightening, and it’s easy to see why the earnings picture could deteriorate more quickly than normal.
Bottom-up Wall Street estimates still suggest that earnings could bounce back in the second half of the year, but the optimism has been waning quickly, and the pace of revisions is often more telling than the forecasts themselves. Sell-side projections are, after all, largely a function of company guidance, and executives have been methodically walking outlooks lower for several quarters now. The earnings season that starts next month could bring further revisions to the downside.
In many respects, it feels as if this particular cycle is unfolding about six months ahead of schedule. That would make some sense, given the ways financial markets work now and the rapid-fire nature of the policy rate hikes. It would also explain why this episode seems somewhat out of sync with history.
Instead of waiting for the Fed to pause, the Treasury market and stocks pivoted, in practice, back in October, and savvy traders rode the wave. Investors who waited for the actual pause missed the trade. The economy isn’t necessarily breaking just yet, but unforeseen shocks are chipping away at companies’ earnings foundations.
That doesn’t mean the party is over. If this a 1990s redux and company earnings can regain their footing, there could yet be some serious money to be made jumping on the bandwagon. If this is 2000 or late 2006, there are serious risks on a horizon that’s probably closer than meets the eye. But as the Fed finally winds down its rate-increase campaign, one thing is clear: This is anything but a typical market, and investors would be reckless to bet on an average outcome.
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