The Song Remains the Same? Higher Rates Don’t Typically Kill Bull Markets

Key Points

  • Slow tightening cycles tend to be rewarded by much better equity returns than fast cycles.
  • Rising rates don’t always lead to bear markets or recessions.
  • Full rising rate cycles tend to bring only slightly lower-than-normal equity returns; but higher economic and job growth.

Because we don’t anticipate any fireworks—or even notable news—out of the July Federal Reserve meeting, we are not publishing a dedicated report on the meeting or the accompanying statement. However, we are keenly aware of the attention on the Fed and the likelihood it begins raising short-term term interest rates this year. Our view remains that September is the most likely month, barring any significant change in the trajectory of job growth in the next two months.

This report will be a quick highlight of some of what I’ve discussed recently; and possibly some new data you may not have seen. First, I want to highlight again that it’s the path of interest rate hikes that is more important than the start date of the cycle. This is not only our view at Schwab; Fed Chair Janet Yellen made it clear in her recent Congressional testimony that it’s her view as well.

Slow ride

Given the high likelihood that the cycle this time will be of the “slow” variety rather than “fast;” implications for stocks, based on history, are important. Before showing the chart, let me offer the definitions. We have not seen a slow tightening cycle since the 1977 cycle; but it is defined as one when the Fed doesn’t hike at every (or even most) consecutive Fed meetings. This is in contrast to every cycle since the late-1970s—under the Chairmanships of Paul Volker, Alan Greenspan, and Ben Bernanke—when rates were raised at most-if-not-all consecutive Fed meetings.

There is also the possibility of a one-or-two-and-done rate hike, or a “non-cycle.” There have been four such cases in the post-World War II era: 1968 (two hikes), 1971 (one), 1984 (one) and 1997 (one). Those are represented by the green line in the chart below. If the Fed goes down this path, Ned Davis Research notes that the “why” is as important as the “what.” “If the Fed decides that inflationary pressures are benign enough that merely getting off the zero bound achieves their goals, then the market could behave similar to other non-cycle cases.”

As you can see in the chart, slow and non-cycles were rewarded by much better equity returns in the year following the initial hike versus fast cycles (although the non-cycles initially underperformed all other experiences). The lines are based at 100 at the start date of each cycle; but let me give you the punch line numbers: one year after non-cycles began, the stock market was up 11.5% on average; one year after slow cycles began, the stock market was up 10.8% on average; while one year after fast cycles began, stocks were down 2.7% on average. That is a big difference.

Slow vs Fast Tightening Cycles

Slow vs Fast Tightening Cycles

Fast cycle dates: 11/20/67, 1/15/73, 9/26/80, 9/4/87, 2/4/94, 6/30/99, 6/30/04. Slow cycle dates: 4/25/46, 4/15/55, 9/12/58, 7/17/63, 8/31/77. Non cycle dates: 12/19/68, 7/16/71, 4/9/84, 3/25/97. Cycles were set at, or indexed to, 100 to enable growth comparisons. Past performance is no guarantee of future results. Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015© Ned Davis Research, Inc. All rights reserved.).

Bears tend to hibernate for a while

But let’s look longer term, and also at the economic impact of a rising rate cycle. We know rising rates often lead to bear markets and/or recessions; but as you can see in the table below, not necessarily…and not right away typically. The table highlights every initial rate hike since the mid-1950s and subsequent bear markets and recessions.

Fed tightenings ahead of US bear markets and recessions

Bear market defined as 20+% drop in S&P 500. Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015© Ned Davis Research, Inc. All rights reserved.).

Not every rate hiking cycle led to a bear market—the 1977 cycle is a great example because it was the aforementioned last slow tightening cycle we had in the United States. And, the recession which followed was over two years later. Earlier, we have the 1963 example, which saw the bear market hibernate for 31 months before arriving; while there was ultimately no recession associated with that cycle. And then there was the 1994 cycle, which was accompanied by neither a bear market nor a recession.

Of course, there are exceptions in the other direction. When the Fed began raising rates in 1973, the bear market was already underway and the brutal recession of 1973-1974 was less than a year away. But the median numbers are worth digesting: it’s been a median 12 months between initial rate hikes and bear markets; and 25 months between initial rate hikes and recessions. But let’s not forget that bear markets and recessions tend to arrive when monetary policy becomes overly tight—not likely for quite some time in this cycle—or when economic excesses build up—also not likely for quite some time in this cycle.

Economy historically resilient

Let’s look even longer term now and show how the stock market, the economy and job growth performed over entire rate hike cycles. The table below highlights every rate hike cycle—from the first hike to the final hike—since the mid-1950s. Over those spans, you can also see the performance of the stock market; economic growth (using the “Coincident Index,” a monthly proxy for gross domestic product); and job growth (using nonfarm payrolls).

Economic and market performance during rising interest rate periods

Tightening cycle defined as at least 3 consecutive rate increases without an intervening easing cycle. Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015© Ned Davis Research, Inc. All rights reserved.).

The conclusion from the data above is that although the stock market had subdued returns relative to the norm over the entire history when the Fed was hiking rates, the returns were still generally positive. The only negative occurrences for stocks—in 1973-1974 and 1987-1989—were a function of the aforementioned brutal 1973-1974 bear market/recession and 1987 stock market crash, respectively.

As for economic growth, it makes intuitive sense that growth during tightening cycles exceeded the norm given that stronger economic growth is typically the trigger for the Fed to be hiking rates. The same applies to job growth, which was historically well above the norm when the Fed was hiking rates.

In sum

Volatility is normal and to be expected as the Fed moves toward an initial rate hike—and we are in a unique era with the Fed having kept short rates near zero for six-and-a-half years. But a slow process toward higher rates will not likely doom the bull market. It will send a message that the Fed is beginning the normalization process—and believes it no longer needs to treat the economic patient like it’s still in in the trauma room. This could even provide a boost of confidence—to investors, to homebuyers and to businesses.

Important Disclosures

© Charles Schwab

© Charles Schwab

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