Equity Bulls Count on Fed-Cycle Math That Worked For Decades

(Bloomberg) — At first blush, stock bulls on Wall Street have history on their side if the Federal Reserve’s aggressive policy-tightening campaign really is drawing to a close.

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Over eight previous monetary-tightening cycles, the S&P 500 ended up higher by an average 13% a year after the last interest-rate increase, per Strategas Securities. Meanwhile the famous American consumer remains largely alive and well, first-quarter corporate earnings are reviving Big Tech and supply bottlenecks are easing. All that raises the possibility of a fresh bull cycle ahead akin to the mid-90s.

Yet money managers aren’t jumping in — with another $2.7 billion pulled from US equity funds in the week through April 26 according to EPFR Global.

The fear is, higher borrowing costs risk stoking continued turmoil in the banking sector while curtailing credit in crucial corners of the US economy. History, meanwhile, provides cautionary tales. In the 1970s and again during the dot-com bubble, an overdose of monetary medicine, among other things, hurt the economy.

That’s why the Fed’s policy decision Wednesday, when another rate-hike is expected, is a critical moment in the tug-of-war between bulls and bears — and may lay out traps for market timers ahead.

“Timing the market is risky,” said Tony Roth at Wilmington Trust Investment Advisors, who predicts the S&P 500 will be range-bound for the remainder of the year and could drop as low as 3,600 as economic conditions worsen. “Once we can see through inflation, to when the Fed starts to cut rates, then we’ll be in the next cycle, and equities will be able to thrive,” he said. “But that is not going to happen, by our estimation, until next year.”

History has shown that buying stocks at the end of a hiking cycle has proven to be a winning strategy in relatively low-inflationary environments like in the 1990s. But in the wake of inflationary pressures in the 1970s and beyond, stocks fell in the three months after every last hike, according to Bank of America Corp.

That’s one reason Michael Hartnett, BofA investment strategist, has called for investors to “sell the last rate hike.” He expects that the S&P 500’s rally will be thwarted by falling profits and growing threats of a recession.

Meanwhile, there are no guarantees that market-friendly rate cuts are coming soon even as swap traders en masse price in easier monetary policy ahead. After all, the Fed has never eased borrowing costs when the unemployment picture — currently near a half-century low of 3.5% — has looked this benign.

Read more: US Inflation Pressures Persist, Reinforcing Case for Fed Hike

With mixed signals on the economic trajectory ahead, plenty of investors are sitting on the sidelines.

“We don’t know how long it will take for the economy to really slow to the point of a recession,” said Shaniel Ramjee, senior investment manager at Pictet Asset Management, whose firm is marketweight US stocks. What’s holding Ramjee back from joining the equity rally of late: Concerns over the financial system following multiple bank collapses last month.

Economic Trajectory

The Conference Board Leading Economic Index has been negative for 12 consecutive months. In the past 50 years, there were just three instances when that happened — 1974, 1980 and 2008 — and each time the US economy was already in a recession, according to Michael Sheldon, chief investment officer at RDM Financial Group.

Forecasters surveyed by Bloomberg are predicting that the economy will contract in the third and fourth quarters. But the likes of Ramjee of Pictet think the economy may skirt a downturn for longer. The US savings cushion, for example, looks healthy at 5.1% in March for the highest since December 2021.

“Instead of a recession, the economy is more likely headed for multiple quarters of low growth,” Ramjee added. “It’s possible that stocks could still rally by the end of the year. It’s dangerous for investors to get too defensive too early — or for too long.”

–With assistance from Elena Popina.