Are you wondering how the stock market has performed during previous Fed-rate-hike cycles? This article will explore whether stocks perform well or poorly when borrowing costs rise.
On March 16, 2022, the Federal Reserve approved its first rate hike since December 2018. 11 Fed rate hikes later, the Fed Funds rate is at 5.25% – 5.5% to combat what was once 40-year high inflation in 2022. The Fed-rate-hike cycle is about over.
However, the 10-year bond yield is at about 4.2%, meaning the yield curve is inverted. With an inverted yield curve, fears of another recession within the next 12 months is increasing. However, the fears of a recession have last since 2022, and have not materialized so far.
Inflation has proven stickier than expected unfortunately. Here are some straightforward ways to combat inflation if you want to reduce costs.
The impact to borrowing costs won't be that great if the Fed hikes gradually. Consumers on variable rates will have plenty of time to refinance to a fixed rate. Unfortunately, the Fed has been aggressive and both consumer borrowing costs and mortgage rates have increased tremendously.
Let's discuss how the stock market has historically performed during Fed-rate-hike cycles. We'll also look at how specific sectors have performed when interest rates are rising.
How Fed Rate Hikes Affect Stock Market Returns
During the previous four rate hike cycles, equity markets ended up performing well over the next 12 months. Unfortunately, 2022 turned out to be a bear market, with the S&P 500 down about 19.6%. It was down worse at one point.
Take a look at this great chart created by LPL Research and Bloomberg. It shows the S&P 500 is positive 50%, 75%, and 100% of the time three months, six months, and 12 months after the first rate hike. Based on 2023 stock market performance, it looks like we'll have another winning year 12 months out.
Therefore, based on historical performance, we should stay invested for as long as possible. Tell yourself to hold on for at least a year. Instead of selling stocks during a correction or bear market, buying stocks may be more appropriate.
The only time we should be selling stocks is if we realize our risk exposure is too great. And the only way of really knowing whether our risk exposure is too great is to go through a down market and analyze how you feel.
During up markets, we tend to feel more risk-loving than we really are. It's easy to confuse brains and courage during a bull market. See how stocks perform under different political presidents too.
Unfortunately, the Fed embarked on the quickest and most aggressive rate hike in decades in 2022 and 2023.
How S&P 500 Sectors Perform In Fed Rate-Hike Cycles
Here's a great chart from Strategas Securities. It breaks down the average annualized return by S&P 500 sector during Fed-rate-hike cycles. Technology, Real Estate, Energy, Health Care, and Utilities performed the best. These sectors outperformed the S&P 500 when interest rates were rising.
Why Tech Stocks Outperform In A Rising Interest Rate Environment
Some of you may be surprised the technology sector is the best performing S&P 500 sector during historical Fed-rate-hike cycles. The technology sector is usually more sensitive to rising rates given a higher discount rate reduces the present value of its expected cash flow when conducting a DCF analysis.
Technology stocks tend to trade more on future expected earnings, which are more uncertain, versus say, the utilities sector. And in 2023, tech stocks have proven to be the biggest winners.
One reason S&P 500 tech earnings are less sensitive to changes in interest rates than other S&P 500 sector earnings is because tech companies usually have less debt financing than non-tech sectors. Gorillas like Apple, Google, and Microsoft are cash cows with massive balance sheets. Therefore, they would actually earn higher interest income than those companies with weaker balance sheets when rates go up.
Another reason the technology sector tends to perform well during a Fed-rate-hike cycle is that technology stocks do not sell big-ticket items their customers have to finance. For example, most people buying Apple Air Pods can pay cash or charge it on a credit card and pay it off after one billing cycle. The same goes for subscribing to cloud software.
Here's an interesting chart that shows how valuations for the S&P 500 technology sector sometimes increases as the 10-year Treasury yield increases. Fascinating stuff!
With many technology stocks beaten to a pulp since November 2021, investing in technology stocks now looks more enticing. I'm buying more shares in tech leaders such as Google, Amazon, Nvidia, and Apple. I've owned these names for years. I'm also nibbling on bombed-out names like DocuSign and Affirm.
Disclaimer: Please do your own due diligence. Do not invest in something you don't understand. Your investment choices are yours alone. There are no guarantees with any risk investments.
Why Real Estate Tends To Outperform When Interest Rates Are Rising
The real estate sector tends to do well because real estate benefits more from rising rents than it gets hurt by rising mortgage rates. Further, given real estate is a key component of inflation, real estate tends to ride the inflation wave.
The Federal Reserve tends to hike the Fed Funds Rate in a strong economic environment, not a weak one. Therefore, real estate tends to outperform when interest rates are rising because the strength of the labor market, corporate earnings, and wage growth overwhelms rising borrowing costs. As a rental property investors, you want to hold on when inflation is elevated.
But here's a point worth repeating. Mortgage rates don't necessarily rise as much when the Fed hikes rates. Take a look at this Federal Reserve Economic Data (FRED) chart comparing the average 30-year fixed-rate mortgage and the effective Federal Funds rate.
It is highly likely that mortgage rates will trend downward again as inflationary pressures wane. In fact, many institutions have upgraded their outlooks for home prices in 2023 and 2024. Zillow forecasts housing prices will increase by 6.5% through July 2024. That's hugely bullish if it happens.
Where Will Mortgage Rates Be By The End Of The Fed Rate-Hike Cycle?
There are two important observations from the chart above.
The first observation is that interest rates have been declining since the 1980s. Therefore, taking out an adjustable-rate mortgage (ARM) over a 30-year fixed-rate mortgage is the better move. You can refinance before the ARM adjusts or if it does adjust. The rate has a high likelihood of staying at a similar rate.
The second observation is the average 30-year fixed-rate mortgage does not go up as much as the Fed Funds Rate during a rate-hike cycle. As a result, mortgage rates, which are more determined by the 10-year Treasury bond yield, don't increase as significantly either.
Look at the periods between 2004 – 2007 and 2016 – 2019. The average 30-year fixed-rate mortgage increased by less than half the magnitude increase of the Fed Funds Rate.
Mortgage Rate Increase Example
30-year fixed mortgage rates are based on spreads above the 10-year Treasury bond yield. The spread generally ranges between 1.5% to 3%. For example, if the 10-year bond yield rises to 4.5%, we can expect a 30-year fixed rate mortgage to average 6% to 7.5%.
Watch out for negative real mortgage rates during a high inflation environment as well. Negative real mortgage rates are great for borrowers as inflation inflates away the cost of debt. Further, wages and corporate earnings will continue to grow, strengthening both consumer and corporate balances.
As a result, buying single-family rentals and multifamily properties makes sense. So is investing in build-to-rent funds and other private real estate funds that specialize in rental properties. Half of my net worth is in real estate partially because I believe in history. I also like the stability and utility of real estate.
A Resilient And Strong Economy
The speed of change is increasing in the financial markets. Oil might surge by 30% one week and collapse by 30% a couple weeks later. This would make a recession suddenly less likely. The Federal Reserve could hike by 3% over five meetings. Then they might change its mind and pause due to another damn COVID variant.
Despite all these moving parts, the one thing we do know is that the U.S. economy is resilient. We, the people, are also resilient. Therefore, the optimal decision is to stay invested in U.S. stocks and real estate over the long term.
Sure, we may have strong home country bias. However, I wouldn't bet against the American people. We will find ways to adapt and overcome future challenges. As a result, we will continue to grow more prosperous long term.
Diversify Your Investments In Real Estate
Stocks have historically provided long-term appreciation, but they are volatile. To reduce volatility while increasing wealth, diversify your investments into private real estate. You no longer have to own physical rental property to manage. Take a look at my favorite to private real estate platforms.
Fundrise: A way for all investors to diversify into real estate through private funds with just $10. Fundrise has been around since 2012 and manages over $3.3 billion for 400,000+ investors.
The real estate platform invests primarily in residential and industrial properties in the Sunbelt, where valuations are cheaper and yields are higher. The spreading out of America is a long-term demographic trend. For most people, investing in a diversified fund is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. These cities also have higher growth potential due to job growth and demographic trends.
If you are a real estate enthusiast with more time, you can build your own diversified real estate portfolio with CrowdStreet. However, before investing in each deal, make sure to do extensive due diligence on each sponsor. Understanding each sponsor's track record and experience is vital.
I've invested $953,000 in real estate crowdfunding so far. My goal is to diversify my expensive SF real estate holdings and earn more 100% passive income. I plan to continue dollar-cost investing into private real estate for the next decade.
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