On March 16, 2022, the Federal Reserve approved its first rate hike since December 2018. The Federal Reserve was more aggressive than expected, indicating it plans to hike rates at each of the six remaining meetings in 2022. The assumption now is that by the end of 2022, the Fed Funds Rate will be in the range of 1.75% – 2%.
The committee sees three more hikes in 2023 then none the following year. Could the Fed Funds Rate really be at 2.5% – 2.75% by the end of 2023? If inflation stays over 6% in 2022 and over 4% in 2023, the probability is likely. But a lot can change over the next two years to make the Fed stop.
If the Fed follows a gradual 0.25% hike at each meeting, then the impact to borrowing costs won’t be that great. Consumers on variable rates will have plenty of time to refinance to a fixed rate. Further, Treasury bond yields won’t necessarily follow the Fed Funds Rate higher in lockstep. Therefore, mortgage rates may not go up as much.
In this article, let’s discuss how the stock market has historically performed during Fed-rate-hike cycles. We’ll also look at how specific sectors have performed when interest rates are rising.
How Fed Rate Hikes Affect Stock Market Returns
Great news! During the previous four rate hike cycles, equity markets ended up performing well over the next 12 months.
Take a look at this great chart created by LPL Research and Bloomberg. It shows the S&P 500 is positive 50%, 75%, and 100% of the time three months, six months, and 12 months after the first rate hike.
Therefore, based on historical performance, we should stay invested for as long as possible. Tell yourself to hold on for at least a year. Instead of selling stocks during a correction or bear market, buying stocks may be more appropriate.
The only time we should be selling stocks is if we realize our risk exposure is too great. And the only way of really knowing whether our risk exposure is too great is to go through a down market and analyze how you feel.
During up markets, we tend to feel more risk-loving than we really are. It’s easy to confuse brains and courage during a bull market.
How S&P 500 Sectors Perform In Fed Rate-Hike Cycles
Here’s a great chart from Strategas Securities that breaks down the average annualized return by S&P 500 sector during Fed-rate-hike cycles. Technology, Real Estate, Energy, Health Care, and Utilities performed the best and outperformed the S&P 500 when interest rates were rising.
Why Tech Stocks Outperform In A Rising Interest Rate Environment
Some of you may be surprised the technology sector is the best performing S&P 500 sector during historical Fed-rate-hike cycles. The technology sector is usually more sensitive to rising rates given a higher discount rate reduces the present value of its expected cash flow when conducting a DCF analysis. Technology stocks tend to trade more on future expected earnings, which are more uncertain, versus say, the utilities sector.
However, the empirical evidence shows otherwise.
One reason S&P 500 tech earnings are less sensitive to changes in interest rates than other S&P 500 sector earnings is because tech companies usually have less debt financing than non-tech sectors. Gorillas like Apple, Google, and Microsoft are cash cows with massive balance sheets. Therefore, they would actually earn higher interest income than those companies with weaker balance sheets when rates go up.
Another reason the technology sector tends to perform well during a Fed-rate-hike cycle is that technology stocks do not sell big-ticket items their customers have to finance. For example, most people buying Apple Air Pods can pay cash or charge it on a credit card and pay it off after one billing cycle. The same goes for subscribing to cloud software.
Here’s an interesting chart that shows how valuations for the S&P 500 technology sector sometimes increases as the 10-year Treasury yield increases. Fascinating stuff!
With many technology stocks beaten to a pulp since November 2021, investing in technology stocks now looks more enticing. I’m buying more shares in tech leaders such as Google, Amazon, Nvidia, and Apple. I’ve owned these names for years. I’m also nibbling on bombed-out names like DocuSign and Affirm. Please do your own due diligence.
Why Real Estate Tends To Outperform When Interest Rates Are Rising
The real estate sector tends to do well because real estate benefits more from rising rents than it gets hurt by rising mortgage rates. Further, given real estate is a key component of inflation, real estate tends to ride the inflation wave.
The Federal Reserve tends to hike the Fed Funds Rate in a strong economic environment, not a weak one. Therefore, real estate tends to outperform when interest rates are rising because the strength of the labor market, corporate earnings, and wage growth overwhelms rising borrowing costs.
But here’s a point worth repeating. Mortgage rates don’t necessarily rise as much when the Fed hikes rates. Take a look at this Federal Reserve Economic Data (FRED) chart comparing the average 30-year fixed-rate mortgage and the effective Federal Funds rate.
Where Will Mortgage Rates Be By The End Of The Fed Rate-Hike Cycle?
There are two important observations from the chart above.
The first observation is that interest rates have been declining since the 1980s. Therefore, taking out an adjustable-rate mortgage (ARM) over a 30-year fixed-rate mortgage is the better move. You can refinance before the ARM adjusts or if it does adjust, the rate has a high likelihood of staying at a similar rate.
The second observation is the average 30-year fixed-rate mortgage does not go up as much as the Fed Funds Rate during a rate-hike cycle. As a result, mortgage rates, which are more determined by the 10-year Treasury bond yield, don’t increase as significantly either.
Look at the periods between 2004 – 2007 and 2016 – 2019. The 10-year bond yield increased by less than half the magnitude increase of the Fed Funds Rate. I’m confident the same thing will happen again in this rate-hike cycle.
Let’s say the Fed Funds Rate does indeed increase to 1.75% – 2% by the end of 2022. Based on history, we can expect the average 30-year fixed-rate mortgage to increase by 0.75% – 1% to 4.75% – 5%. If the Fed hikes another three times in 2023 to 2.5 – 2.75%, then we can expect the average 30-year fixed-rate mortgage to increase to 5% – 5.375% two years from now.
Consumers will have ample time to refinance before then. Mortgage rates will still have negative real mortgage rates during the majority of this time. Further, wages and corporate earnings will continue to grow, strengthening both consumer and corporate balances.
As a result, buying single-family rentals and multifamily properties makes sense. So is investing in build-to-rent funds and other private real estate funds that specialize in rental properties. Half of my net worth is in real estate partially because I believe in history.
A Resilient And Strong Economy
The speed of change is increasing in the financial markets. Oil might surge by 30% one week and collapse by 30% a couple weeks later, making a recession suddenly less likely. The Federal Reserve could hike by 1.25% in over five meetings only to change its mind and pause due to another damn COVID variant.
Despite all these moving parts, the one thing we do know is that the U.S. economy is resilient. We, the people, are also resilient. Therefore, the optimal decision is to stay invested in U.S. stocks and real estate over the long term.
Sure, we may have strong home country bias. However, I wouldn’t bet against the American people. We will find ways to adapt and overcome future challenges. As a result, we will continue to grow more prosperous long term.
Disclaimer: Please do your own due diligence. Do not invest in something you don’t understand. Your investment choices are yours alone. There are no guarantees with any risk investments.
For more nuanced personal finance content, join 50,000+ others and sign up for the free Financial Samurai newsletter. Get your posts in your inbox by signing up here.