Recent commentary from United States Federal Reserve Chairperson Janet Yellen confirms our view that US official interest rates will rise this year. While our bullish view on the US economy had earlier led us to think the Fed could tighten in the first half of the year, it now appears likely the first move will take place by September – with a moderate chance the Fed could still act next month.
So what are the implications of Fed tightening for financial markets? Our core view – based on historical and fundamental analysis – is that while equity markets may weaken in the early stages of Fed tightening (say the first few months), equities should remain well supported by solid corporate earnings and still reasonable valuations against the backdrop of likely continued low bond yields. As seen in the chart below, it is only in the latter stages of a Fed tightening cycle – when interest rates are clearly restrictive – that equity bear market conditions tend to develop.
This is also apparent in the chart below, which details the performance of the S&P 500 index in the year following the first Fed tightening during the cycles of 1994, 1999 and 2004. While equity prices were lower 3-months after the first tightening move, they were higher by the 6-month and 12-month period in the 1999 and 2004 cycles. In 1994 – a particularly aggressive tightening cycle – equity prices remained down six-months after the first rate hike, but had largely recovered all their earlier losses within 12 months.