What does a Fed rate hike mean for your portfolio?

What Fed rate hikes may mean for your portfolio

You’ve likely noticed higher prices at the grocery store, the gas pump and other retailers. The return of high inflation is a notable feature of the post-pandemic economy.

With consumer prices spiking for nearly a year now, the Federal Reserve is shifting gears to help curb inflation. This year’s expected series of rate hikes, the first since 2015, marks the beginning of Fed policy normalization. But it also has increased market volatility and changed sector leadership so far this year.

The economy: no help needed

Some experts fear removing the Fed’s emergency accommodation will end the economic expansion prematurely, but we believe the economy is strong enough to handle any interest rate hikes. GDP is growing at an above-average pace, and the unemployment rate has declined near historic lows. Also, longer-term rates are still negative in real terms (after accounting for inflation).

While lifting the policy rate from zero is unlikely to choke off the economy, in our view, the rise in borrowing costs and the withdrawal of support will likely mean more volatility and pressure in market valuations.

^{Source: FactSet as of 1/31/21
1 Prior three-quarter real GDP average.
2 10-year Treasury yield minus CPI.}

Compressed valuations vs. rising earnings

Looking at the five previous tightening cycles since 1985, stock valuations tended to fall when the Fed raised interest rates and the cost of money rose. For example, the S&P 500 price-to-earnings ratio declined 20% on average between the first and last Fed hikes. But stronger earnings growth tended to outweigh the negative effect of valuation compression in past cycles, and stocks gained overall.

We think this time will be similar, with earnings well-supported by a growing economy, resilient profit margins and healthy corporate balance sheets. With a tug-of-war between valuation pressures and rising earnings, equity market returns should be moderate but stay positive, in our view.

This may change if the Fed overtightens, but this tends to happen at the end of a rate-hiking cycle rather than the beginning. A few warning signs are an inverted yield curve, rising credit spreads and weakness in interest rate-sensitive economic sectors (such as housing and autos), but none of these are close to flashing red yet.

What you need to know now

Although we expect to see higher levels of volatility and lower returns in 2022, this doesn’t mean an end to the bull market, in our view. Stocks have historically experienced some weakness around the first interest rate hike. Generally, though, they’ve continued to rise six months and a year out, but past performance is not a guarantee of future results. We recommend staying opportunistic during any Fed-induced pullbacks or corrections.

As central banks tighten policy amid the economic expansion, we think long-term yields will grind higher. Rising yields will likely continue to challenge fixed-income-returns, but we still expect bonds to play an important part, helping to stabilize portfolios during volatility. With credit spreads expected to stay low, an appropriate allocation to domestic and international high-yield bonds might help enhance returns.

Equity markets can absorb higher bond yields, but valuation pressures on growth-style investments could continue. Value investments, which have lagged meaningfully in recent years, might see the pendulum swing their way.

International markets are also trading at lower valuations. Unlike U.S. markets, their sector composition is tilted toward value and cyclical sectors. If pandemic conditions improve and global rates rise, we think international diversification will likely help returns.

A potentially softening U.S. dollar could also provide a tailwind. Historically, the dollar has risen in the months leading up to the start of a Fed hiking cycle, but it has tended to fall during the first six months after the first interest rate hike.

^{Source: FactSet, Morningstar Direct, S&P 500 total returns.}