What happens to stock markets when the Fed hikes rate: A peek into history

Reuters

The S&P 500 Index is off to its worst start to a year since the Covid-fueled selloff in March 2020, and now investors have to contend with rising interest rates possibly starting at Wednesday’s Federal Reserve meeting.

Over the past two years the stock market has managed to rise in the face of the worst global pandemic in a century, one of the most divisive presidential election in U.S. history and the Capitol being attacked by Americans upset over the results of that election. Now it’s facing the largest ground war in Europe since World War II, and the fastest inflation since the 1980s.

So with the Fed preparing to hike rates, it’s worth wondering if the S&P 500, which is still up almost 90% since bottoming on March 23, 2020, is running out of steam.

Here’s a look at what history says about the U.S. stock market when the Fed starts raising rates:

History of Rate Hikes

History suggests U.S. stocks are poised to experience more volatility following the rise in rates. But that doesn’t mean the bull run is over. In fact, in the previous eight hiking cycles the S&P 500 was higher a year after the first increase every single time, according to LPL Financial.

Sector Performance

In the past three decades, the Fed has taken on four distinct rate hike cycles. None have been detrimental equity markets. And technology, which has seen wild swings this year on the prospect of faster rate increases, is typically among the best performing S&P 500 sectors during those cycles, with a gain of nearly 21%, according to Strategas Securities. But overall, leadership varies with no sector outperforming in all four instances, the data show.

Oil Shock Dilemma

So what could be a tripwire for this bull run? Rising oil prices coupled with rate hikes. The Fed faces a tricky dilemma with crude surging and Russia’s invasion of Ukraine threatening to make it even more expensive. Oil shocks have preceded economic downturns in the mid-1970s, early 1980s and early 1990s. But other recessions, like after 9/11 in 2001 and the global financial crisis in 2008, weren’t directly caused by a sharp rise in crude prices.

Midterm Volatility

There’s another challenge facing investors this year: U.S. midterm elections in November. Market returns tend to be muted early in these years due to uncertainty on the outcome and subsequent effects on policy changes. But stocks typically post a strong rally at year-end. Taken together, midterm years have seen the largest intra-year pullbacks, down more than 17% on average, according to LPL Financial. This quarter and the next two are historically some of the weakest of the four-year presidential term.

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