With tapering has continued on schedule and the futures market puts the first Federal Reserve rate hike about twelve months out, putting tightening within many asset managers’ investment horizon for the first time in years. With that in mind Goldman Sachs analysts David J. Kostin, Amanda Sneider, and Ben Snider looked back at the relative performance of stocks and bonds in previous tightening cycles and predict that equities will outperform with a 6% annualized return through 2018 compared to just 1% for 10 year Treasuries.
Interest rate hikes have followed market rises in the past
“During the three previous ‘first’ interest rate hikes (1994, 1999, and 2004) S&P 500 (INDEXSP:.INX) rose appreciably in the year prior to the hike, and declined in the subsequent one and three-month periods,” write Kostin, Sneider, and Snider.
This isn’t a surprise, rate hikes are often used to put a slight brake on economic growth when there is a danger of overheating, so the period ahead of a rate hike should correspond with strong market returns. But the correlation may not be that useful for making investments since it assumes the futures market is correct. Put another way, if rates go up in 3Q15 then it will probably be true that the year in between was marked by steady growth, and if the economy stagnates then the rate hike will likely be postponed – but that doesn’t tell you which of the two is going to happen.
S&P 500 future valuation sensitive to neutral fed funds rate
Kostin, Sneider, and Snider acknowledge that some people believe the US is in a state of secular stagnation and that this could keep the neutral fed funds rate as low as 2% (PIMCO’s New Neutral paradigm is on example of this argument).
On the one hand the lower discount curve implied by a 2% neutral fed funds rate means that equities have a higher present value because future dividends are worth more right now, but slower growth implies that dividends would start to fall off. Overall, they expect a lower Fed Funds rate to lower S&P 500 valuations.
“A 50-basis point decline in trend US economic growth rate translates into a roughly 10% reduction in the year-end 2018 valuation of the S&P 500. In contrast, a 50-basis point decline in the neutral interest rate is associated with a roughly 9% increase in the S&P 500,” they write.