Last week, news that inflation eased more than expected in October solidified the view that the Federal Reserve has ended its most aggressive interest rate hike campaign in 40 years.
And that can be a boon for the stock market and your 401(k).
Over the past 10 rate hike cycles since 1974, the S&P 500 index has risen an average of 14.3% in the 12 months following the Fed’s last rate hike, according to an analysis by Ryan Detrick, chief market strategist at Carson Group.
By comparison, the index’s average return through 2022 is 7.5% over five years, 10.4% over 10 years, 7.5% over 30 years, and 10% over the past 100 years. Nerd wallet.
Investors would very much like to see central banks stop overwhelming investors with interest rate hikes.
What happens when the Fed raises interest rates?
Rising interest rates will drive up costs Detrick said mortgages, auto loans, credit card purchases and other loans are stymieing economic activity and squeezing corporate profits. Also, stocks are relatively less attractive investments than bonds because there is less risk to the currently rising yields.
Of course, this pain is ostensibly for a good reason, with inflation locking in and potentially causing even more damage, at least according to the Fed.
A pause in rate hikes does the opposite, brightening the economic outlook and making stocks more attractive than bonds. It also removes a large cloud of uncertainty from the market, said Adam Turnquist, chief technical strategist at LPL Financial.
Is the stock market recovering?
From the day the Fed began raising interest rates in March 2022 until Monday of this week, the S&P 500 index had some wild swings, but ultimately stalled at 4,411. However, the benchmark stock index has risen more than 100 points, or 2.3%, since the Labor Department released its positive Consumer Price Index report early Tuesday.
“If July was the last rate hike, which we think is the case, the year after that last rate hike, stocks have historically done pretty well,” Detrick said.
LPL Financial’s Turnquist called this a “catalyst for the stock market.”
There are a few things to keep in mind.
First, Fed officials say they haven’t ruled out another rate hike despite the encouraging inflation report, although most economists think so.
How will interest rate suspension affect the market?
And while the end of rate hikes has resulted in double-digit market gains in eight of the 10 rate hike cycles over the past half-century, in two of those, the S&P 500 index suffered significant 12-month declines. Halting interest rate hikes in July 1981 did not stop the market from falling 16.4% in the midst of a brutal recession caused by interest rates still in nosebleed territory above 17%.
Similarly, ending interest rate hikes in June 2000 did not avert the dot-com bust of 2001.
“The (dot-com) bubble had burst, and the impact of the pause and subsequent rate cuts was limited,” Turnquist said.
At the other end of the spectrum, the Fed’s decision to halt large rate hikes in 1995 and then lower them likely helped generate a 35% market return in the year after the last hike. But software-based productivity improvements also fueled a robust economy.
In other words, in most of the Fed’s wait-and-see decisions to date, the Fed has been the “primary driver” of strong market gains, Turnquist said. But sometimes other forces were at play.
These developments could impact stock prices and your 401(k) in the coming months.
What happens in an earnings recession?
For example, in the third quarter, S&P 500 companies appear to have emerged from a year-long earnings slump (characterized by declining quarterly profits), according to recent earnings reports. This could revitalize the market.
Detrick says if recent strong productivity gains, further fueled by artificial intelligence, continue, employers could be able to raise wages without raising prices. .
Are stocks expensive?
At the same time, the stock is relatively expensive at 18.6 times expected earnings over the next 12 months, above the 10-year average of 17.6 times, according to Turnquist and FactSet. That puts more strain on the economy and profits to stay strong, Turnquist said. If the U.S. were to experience a moderate or severe recession, it could hurt markets regardless of what the Fed does or does not do.
Another thing to keep in mind is that the market’s solid rally following the Fed’s decision to suspend interest rate hikes may have been reinforced by subsequent rate cuts. The Fed last raised interest rates in December 2018, contributing to market gains of 11.7% and 17.7% in the following three and six months, respectively.
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However, in August 2019, Fed officials began cutting interest rates, and the S&P return rose to 27.9% in the 12 months after the last rate hike.
In the medium term, stock prices may continue to rise as the Fed remains on the sidelines. But futures markets show investors are expecting a rate cut by May, or sooner.
If the Fed bucks this narrative and continues to stand by its mantra of “longer-term gains,” “stocks could pull back and give up some of this recovery,” Turnquist said.