Excuse this longer-than-usual report, but consider it an "encyclopedia" of sorts associated with the important shift underway in monetary policy.
Market volatility this year so far has both longer-term and shorter-term drivers, including the pending Federal Reserve tightening cycle and the Russia/Ukraine uncertainty, respectively. Although the Russia/Ukraine situation could influence expectations around U.S. and global growth via the energy price channels, it likely won't lead to the Fed veering off its present course to begin raising interest rates, shrinking its balance sheet, and putting pressure on aggregate demand in order to rein in elevated inflation.
The $9 trillion question
Unlike in advance of (or during) some past tightening cycles, the Fed is not operating with a pre-determined policy playbook. That said, Fed speakers—including Chair Pro-Tempore Jerome Powell—have a keen understanding of the power of their words, which have contributed to the tightening of financial conditions already underway. What makes this cycle particularly unique—aside from the implications of the pandemic—is that the Fed plans to embark on a tightening cycle via raising the fed funds rate, while also planning to shrink a $9 trillion balance sheet.
The dual levers the Fed plans to pull separate this cycle from those in the past; however, a look at history can still be instructive. Many thanks are in order for our friends and research partners at Ned Davis Research (NDR), who have a vast database associated with Fed tightening cycles all the way back to WWII. We worked with them in creating most of the charts below and are grateful for their collaboration.
Before getting into our "chartfest" below, let's start with a background table highlighting that rate hike cycles do not always lead to recessions. There were "soft landings" following the 1963, 1994 and 2015 cycles, while those that were followed by recessions had wide variability in terms of lead time.
Source: Charles Schwab, National Bureau of Economic Research (NBER).
Chart background details
Some background is in order before getting to the meat on the bone of the charts below. There are three types of rate hike cycles: slow, fast and "non." Slow cycles are when the Fed was raising rates over a span of time, but also taking its time by not hiking during consecutive months or Federal Open Market Committee (FOMC) meetings.
Conversely, fast cycles—like between 2004 and 2007—were when the Fed was raising rates during consecutive months or FOMC meetings. Finally, "non cycles" where periods when the Fed began raising rates but had to stop after one or two (for myriad reasons). Most of the charts below, unless otherwise indicated, only incorporate the slow and fast cycles, not the non cycles.
Finally, we added in lines for the current lead-in to the initial rate hike, which we are assuming will be announced on March 16, following the two-day FOMC meeting. However, on the charts that have monthly data readings, the start point for the coming cycle is labeled with March 31, 2022.
Stock market during rate hike cycles
Let's start with a version of a chart I put in our 2022 outlook report late last year. The chart below (as well as all others that have three sections) covers the one-year lead-in to the initial rate hike (left field), the first year following the initial rate hike (middle field), and the second year following the initial rate hike (right field). The green line is the current experience, which just extends as a static line thereafter—even though we know that will not be the case.
As shown below, in terms of the S&P 500's performance during the current lead-in in terms of the initial hike in March has been significantly stronger than the average of prior cycles, including both slow and fast cycles. As you can see, although fast and slow cycles historically had similar performance during the lead-in period, it was in the aftermath of the initial hike that a major divergence began. As shown at the top of the middle field, the S&P 500's average performance during slow cycles was +10.5%, while during fast cycles it was -2.7%. Interestingly, in the second year, performance flipped, with the S&P 500 performing better during fast cycles.
Earnings/valuations during rate hike cycles
Earnings and valuations are key drivers of stock market returns, with some interesting trends occurring during past rate hike cycles. As shown below, the current cycle looks nothing like prior cycles—with the pandemic causing an unprecedented surge in earnings following the equally unprecedented plunge the prior year. Historically, the lead-in to fast cycles, as well as during the first year of rate hikes, were characterized by much stronger earnings growth (top of left and middle fields); while that reversed once year two was underway (top of right field).
Due to the slowdown in earnings growth underway, clearly shown above, the start of the coming rate hike cycle comes at a unique time. In terms of valuation, a March initial rate hike would correspond to the second-highest S&P 500 P/E ratio in history. Indeed, the P/E has been coming down thanks to the surge in the denominator (E), but remains historically-elevated.
Key ratios during rate hike cycles
Historically, small cap stocks have been mixed vs. large cap stocks around the first rate hike. As shown in the chart below, during the lead-in so far in the current cycle, the Russell 2000/1000 ratio ranks as the worst performance in history for small caps. One year after the initial rate hike, small caps outperformed only 50% of the time (see table within first chart), implying that other factors drive small/large performance. We believe high-quality small cap stocks have runway for outperformance this year; but the emphasis is on high quality (more on that below).
Past performance is no guarantee of future results.
As shown in the chart below, stocks outperformed bonds in the year leading up to the initial rate hike, with the stock/bond ratio rising in six out of seven cases. The lead-in during this cycle has been even stronger for this ratio, as shown by the dotted line. Stocks did tend to outperform during the first year of the hiking cycle, but by a smaller amount—and with much more volatility. We continue to expect heightened volatility for both stocks and bonds this year.
Finally, as shown in the chart below, a more decisive shift was historically seen from low-quality to high-quality stocks once rate hikes began. Caveat: The 1999 outlier skews the average line shown in the chart, which included the largest gain for low quality relative to high quality—but also the largest subsequent drawdown in the year following the initial rate hike. We continue to emphasize high quality in terms of where we believe leadership will persist this year.
Economic trends during rate hike cycles
The Coincident Economic Index (CEI) is a monthly release that comes alongside the Leading Economic Index (LEI) courtesy of The Conference Board. The CEI is a monthly proxy for broad economic growth and is a more-timely indicator than quarterly gross domestic product (GDP). As shown below, based on past cycles, economic growth did not slow significantly at the start of tightening; however, fast cycles hit growth more than slow cycles once rate hikes were underway (see top of middle and right fields).
A clear difference between the current cycle and past cycles is the very low level of the unemployment rate heading into the initial rate hike (red dotted line in the chart below). The unemployment rate fell during the first year of rate hikes in all but one prior cycle—1980, which was associated with the second leg of the 1980-1982 double-dip recession. We don't expect this coming tightening cycle to dramatically slow job growth, but there is also much less room for improvement given how low the unemployment rate is today.
Inflation is obviously top of mind in this cycle. As shown below, the past year's pace of the consumer price index (CPI) has been the highest since the early 1960s (red dotted line vs. lime-green line). Historically, the Fed's record on inflation is mixed-to-positive; although both 1970s' cycles saw inflation continuing to accelerate during the two years following the initial rate hike.
We continue to expect inflation to ease as the year progresses, with key leading indicators already pointing in that direction. Many of the factors that contributed to last year's initial surge in inflation are fading or reversing—including the pandemic (hope springs eternal), fiscal and monetary stimulus, supply chain bottlenecks, and consumers’ goods-oriented demand.
A balancing act
As noted at the beginning of this report, much of the unique nature of the current environment and coming Fed tightening cycle is attributed to the central bank's balance sheet—both its relatively new existence as a policy tool and massive size. Quantitative easing (QE), the Fed's large-scale purchases of assets, has become a feature (in phases) of the post-Global Financial Crisis (GFC) era, as shown by the shaded segments in the chart below.
QE era ending
Source: Charles Schwab, Bloomberg, as of 2/16/2022.
The Fed balance sheet is the U.S. Federal Reserve System's balance sheet of assets and liabilities. Operation Twist is a monetary policy strategy used by central banks aimed at stimulating economic growth through lowering long-term interest rates which effectively "twists" the ends of the yield curve where short-term yields go up and long-term interest rates drop simultaneously.
On the QT
Only in one tightening cycle (that which preceded the pandemic) has the Fed dealt with the dual levers of adjusting interest rates and the size of its balance sheet. When the idea of shrinking the balance sheet was broached in the mid-2010s, and eventually enacted in 2018, the Fed opted for a runoff strategy—allowing a certain number of bonds to mature each month without the repaid principal being reinvested in new securities—as opposed to the outright active selling of securities being explored today.
In what became known as quantitative tightening (QT), the runoff lasted until September 2019, during which a rupture occurred in short-term credit markets, causing a spike in borrowing rates and the Fed to reverse course. Not long after, with the arrival of the pandemic, the size of the balance sheet swelled beyond its prior peak; and as of mid-February, stood at nearly $9 trillion.
Fed officials have not been shy in their desire to enact QT at a faster pace this time around—a marked shift from the prior tightening cycle when interest rate increases occurred well before a reduction in the balance sheet. With active selling of securities now a clear and likely path, there is potential for a double-barreled tightening impact.
In fact, some economists and strategists have estimated that a $500-$600 billion reduction in the balance sheet may equate to a 25 basis-points hike in the fed funds rate. Should that manifest, it may lend credence to the notion that the Fed can manage to hike interest rates in a less aggressive fashion this year—both in terms of magnitude and pace.
"Fed put" getting put to bed?
The Fed's balance sheet has become a major subject of debate in terms of its potential impact on the stock market. Critics have argued that the central bank has only engaged in QE to save the stock market from intense drawdowns, while defenders point to the brief period in which QE has existed—thus rendering historical analyses and correlations unreliable.
With the current era of easing set to come to an end in short order amid a weakening stock market, geopolitical turmoil, and building concerns over a slowing economy, some investors have posited that the Fed won’t be able to engage in rate hikes or QT for very long.
In other words, a belief in the "Fed put"—a hypothetical level for the stock market (or volatility) at which the Fed must step in to arrest a correction or bear market—is back in vogue. We believe it's potentially hazardous to subscribe to the view that the Fed will halt its policy normalization strictly due to stock market volatility. This has been made clear by none other than Fed Chair Pro-Tempore Jerome Powell himself. In his remarks to the Economic Club of New York on November 28th, 2018 (Liz Ann was in attendance), he stated:
"It is important to distinguish between market volatility and events that threaten financial stability. Large, sustained declines in equity prices can put downward pressure on spending and confidence. From the financial stability perspective, however, today we do not see dangerous excesses in the stock market."
Keen observers will note Powell's emphasis on the separation of financial stability—which doesn’t currently appear to be at risk—and market volatility. While we have had no shortage of volatility this year, that in and of itself is not sufficient evidence to suggest that the broader financial system is weak, and thus is not supportive of the Fed reversing course on its commitment to tighten policy.
We are perhaps currently living out that truth today, with weakness spreading throughout several areas of the market and stability not yet threatened. That may very well assist the Fed in its goal to rein inflation in and tighten financial conditions.
Equities have never been more "important" to economy
The current bull market has ushered in substantial gains for equity investors, which has coincided with record flows into equity ETFs (2021 in fact saw more inflows than the prior three years combined), thus boosting asset holders' equity exposure and sending household stock allocations back near their all-time high.
The rub with that, as shown in the chart below, is the relatively close historical relationship between stock exposure and the subsequent rolling 10-year total return for the S&P 500. Indeed, it remains in what has been the weakest zone for the market's forward returns historically.
Households loaded up on stocks
Source: Charles Schwab, Bloomberg, ©Copyright 2022 Ned Davis Research, Inc.
Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/, 12/31/1951-9/30/2021. Equity allocation (includes mutual funds and pension funds) is % of total equites, bonds and cash.
The consequence of the elevated weight of equities in household portfolios is that a protracted and intense drawdown in the market presents a threat to confidence and consumption. As such, the value of the market relative to the value of the economy—as shown by the "Buffett Indicator" in the chart below—underscores that, through the wealth effect, the economy may feel a tighter pinch when the next bear market arrives.
Stocks' surge relative to growth
Source: Charles Schwab, Bloomberg, as of 9/30/2021.
This doesn't equate to a deterioration in financial system stability or liquidity, though; if that were to occur, the Fed may very well take steps to alleviate any ruptures. Yet, the possibility of continued weakness in stocks—and ultimately, the economy—may end up doing some of the tightening work for the Fed, which reinforces our view that it remains premature to expect a significant number of rate hikes this year, especially when the power of the reduction of the balance sheet is still unknown.
The Fed is on a mission to get off the "zero bound" for the fed funds rate, while also starting to shrink its behemoth balance sheet. Tightening of policy, and financial conditions, will continue to cause market volatility—across both the equity and bond markets. The Fed is not operating with a pre-determined playbook, with the use of the balance sheet as a key policy tool still evolving.
For now, recession risk remains low, but keep an eye on leading economic indicators, as well as the yield curve. Peaks in the former, and inversions in the latter have been consistent recession warnings signals historically. In the meantime, remain diversified and disciplined, with an over-arching focus on quality for the stock-pickers out there.