Will the Markets Dislike a Fed Funds Rate Hike?

The pending Fed policy decision will get plenty of attention, but the economy and earnings hold the real keys to market performance.

Baby Boy Is Fed With A Spoon And Has A Disapproving Expression

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The U.S. Federal Reserve seems poised at last to lift its base interest rate. If the will-they-or-won’t-they drama is finally resolved at this month’s meeting, will it be time for investors to worry?

When it comes to investment strategy, it helps to be historically aware but forward-looking. With this in mind, we at Northern Trust studied how markets reacted to the start of previous Fed rate hike cycles. Because markets seek to discount future events, we measured asset class performance starting six months before the first rate increase. During the past five rate hike cycles, going back to 1986, asset class returns were broadly positive during the first year of the cycle. The one exception was the 1987 Black Monday market crash — an event unrelated to changing policy from the Federal Reserve.

A look at the performance of these cycles, other than the anomalous 1987 period, shows a relatively consistent pattern. The stock market had middling gains of around 3 percent, on average, in the six months before the first hike and an additional 10 percent in the six months following the hike. Fixed-income returns were more muted, with a broad measure of the U.S. bond market generating a positive return averaging slightly more than 1 percent in the six months preceding the first hike, with an additional positive return of just under 1 percent in the subsequent six months.

Every market cycle is different, so we want to balance our appreciation of history with a forward-looking view. Today’s Federal Reserve is dealing with an unprecedented economy and global monetary policy framework. Over the five most recent U.S. cycles, the Fed raised rates by an average of nearly 2.75 percentage points over a period lasting just longer than a year and a half. We expect this cycle to be much slower, as inflation isn’t pushing the Fed, and the U.S. central bank is constrained by the extraordinarily low interest rates in Europe and Japan.

Although we don’t expect a negative surprise on the interest rate front, there is some risk involved in the Fed’s communication of its policy. The Fed needs to provide clarity not only on the expected pace of interest rate normalization but also about plans for management of its nearly $4.5 trillion balance sheet. Optimally, the Fed would combine a rate hike in December with a clear message of continued monetary policy accommodation. The market will look for guidance around a patient and rational approach, and the consistency of this message, given the lack of consensus among the members of the Federal Open Market Committee, may prove a challenge.

Much ink will continue to be spilled in 2016 over the plans and actions of the Federal Reserve, but we don’t expect them to be the prime driver of asset prices over the coming year. History shows that markets generally view increasing interest rates as corroboration of an improving economy, and markets can perform well so long as the Fed doesn’t find itself behind the curve. The more important driver of asset class returns will likely be economic growth and corporate earnings. We think muted — but stable — growth in the developed markets, along with the well-understood slowing growth in emerging markets, is sufficient to support a moderate overweight to risk assets. So although the Fed will get a lot of headlines in coming months, it will likely be the secondary stories that drive financial markets in the year ahead.

Jim McDonald is chief investment strategist for Northern Trust in Chicago.

See Northern Trust Asset Management’s disclaimer.

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