Recent inflation data has tempered expectations for future Federal Reserve (Fed) tightening, including a potential peak in the terminal rate near 5.0% in May or June of 2023. While the market has welcomed this news, history suggests the path to a Fed pivot could be volatile for stocks due to elevated inflation and interest rate risk. However, a light at the end of the Fed’s tightening tunnel has recently emerged.
Headline consumer inflation decelerated last month to 7.7% from 8.2% based on a year-over-year comparison. Core inflation ticked down to 6.3% from 6.5%. While both headline and core inflation measures remain well above the Fed’s 2% inflation target, the data is heading in the right direction. Recent wholesale inflation tells a similar story of a potential peak in pricing pressures. The lower trajectory in inflation has provided the market with much-needed visibility around Fed tightening coming to an end. Fed funds futures suggest the end of the rate hike cycle could come in May or June 2023. While there will be continued debate on the degree and timing of future rate hikes, the one thing most investors seem to agree on is that the terminal rate will likely peak sometime next year.
If we define a policy pivot as simply the end of a rate hike period marked by when the fed funds rate peaked, and not necessarily a shift in policy to rate cuts, there have been nine other major cycles.
- Based on these periods, the S&P 500 historically trades lower into a Fed pivot by around 2% on average (based on a six-month lookback of pre-pivot performance). However, S&P 500 returns after a Fed pivot appear much more promising. The average peak return for the market has been around 17% across a 12-month timeframe. If you factor in the fed funds futures timeline of a May or June peak in the terminal rate, you could see around an 11% second half rally next year on the S&P 500.
- Growth outperformance has historically deteriorated as a Fed pivot approaches. Value tends to lead in the six-month window before a pivot.
- Will growth stage a comeback? History shows growth and value trading higher but largely in line during the six-month period after a Fed pivot. However, growth outperformance typically becomes more pronounced after the six-month post-pivot window. One of the catalysts driving growth’s relative strength likely stems from falling interest rates and inflation.
The bear market in Treasuries this year quickly spilled over into U.S. equity markets. The sharp rise in yields proved to be too much for stocks to handle. Of course, Fed policy underpinned the parabolic jump in interest rates as they tried to combat inflation with unprecedented tightening. As we look ahead, the path of inflation will ultimately dictate the path for monetary policy, interest rates, and stock
Despite some of the recent cooling in inflation data, history implies there is still upside inflation risk into next year. Prior rate hike cycles witnessed core inflation climbing until finally peaking four months after a Fed pivot. On average, core inflation also modestly dipped during a few periods within the three- to six-month window before a Fed pivot.
- Interest rate risk also appears elevated based on prior rate hike cycles. Benchmark 10-year Treasury yields have historically climbed higher until finally peaking near the Fed pivot point.
- Given the market’s sensitives around inflation and interest rates, this data implies stocks could be setting up for a volatile first half of 2023.
Recent inflation data has renewed optimism for a peak in the federal funds rate during the first half of 2023. Even so, it could be a bumpy path for equity markets until there is a clear culmination of Fed tightening. While history may not repeat, it may rhyme with other major rate hike cycles, implying there is upside risk for inflation and interest rates. In addition, the S&P 500 has historically traded lower into a Fed pivot. The current backdrop of Fed tightening into next year should also continue to support value outperformance.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by FactSet and LPL Financial, tracking # 1-05347949.
- US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity..
- The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.