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.
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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.
Read the full article here by Jonathan Levin, Advisor Perspectives.
