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Fed good for equities
On 14 June, the US Federal Reserve raised rates as expected. It was the second rate hike this year, and yet only the fourth increase since December 2015. Almost 10 years after the outbreak of the financial crisis, US rates are now at a paltry 1.25%. So the Fed is continuing with gradual increases. But what exactly does such a ‘tightening cycle’ mean for financial markets?
Tightening means 1) a brake on economic growth, and 2) higher yields on US bonds. And that's bad for equities but good for the US dollar, right? Sounds plausible, sure, yet it doesn't correspond with what we have witnessed during previous rounds of tightening. The table below shows returns on the main asset classes over the last eight periods – since 1973 – during which the Fed consistently raised rates for a protracted period. It takes a bit of effort to decipher it, but the table does contain some interesting information.
The first thing that strikes you are the extremely high returns on commodities, gold in particular. Commodity prices rose an average of 44% over the last eight rounds of tightening by the Federal Reserve. Gold prices even managed a 74% increase. But don’t go and immediately invest all your assets in gold ETFs! Have a closer look at the table. The average return on gold of 74% is dominated by two periods, coincidentally also the two oldest. In three of the eight cycles, the return on gold was negative, and in one period (1980) the return was practically zero. These varying outcomes are reflected in the median return, the ‘middle’ observation of a series of returns, as it were, which gives us just 3.2%. Conversely, the median return on commodities is 45%. In historical terms, commodities were the ‘place to be’ if the Fed was hiking rates.
But equities too would have given you a fair return, contrary to the received wisdom. As a rule, the US central bank raises rates when growth threatens to go too fast. Rapid growth usually goes hand in hand with strong earnings growth, which is of course good news for equities. Global equities in particular do well, with an average return of over 12%. And that's a whole lot better than US equities, which don't even manage a miserable 3%. But there's a reason for that, too. The US economy often runs ahead of the rest of the world's economies. So when the Fed intervenes to put a brake on growth, other regions have yet to reach their peak. And equities outside the US benefit from this. So the narrative that the Fed depresses equity markets by tightening its monetary policies doesn't bear out in reality.
Two more interesting observations. The first is that the US dollar declines during periods of tightening, while higher rates actually make this currency more attractive. So there is a big chance that investors are ahead of the game here. The second is that, despite rising interest rates, government bonds still manage an average (and median) positive return. This is partly because you receive a coupon rate that is often higher than the Fed's short-term interest rate. Another reason is that the yield on long-dated bonds often falls if the economy is likely to grow more slowly in the future due to intervention by the central bank.
Many investors have the tendency to assume that it really will be different this time. And there are arguments in support of this. For example, that this round of tightening by the Fed is coming on the heels of a period of extremely relaxed policies and will last much longer than average. The current period of consecutive growth has now lasted a long time in historical terms, so a recession is possible in the not-too-distant future. For commodities, a cooling Chinese economy could throw a wrench in the works.
Yet I wouldn't cast aside historical precedent entirely. A period in which equities outperform bonds, especially equities outside the US, is not unthinkable. Equities outside the US are relatively cheap and in some regions, such as Europe, growth is only just starting to gain momentum. Also the US dollar, which has been under pressure in recent months, is currently following its historical pattern. Since the first interest-rate hike in December 2015, the currency has declined. So a little caution with the ‘this time is different’ scenario seems wise.