The endlessly discussed, yet-to-happen but highly feared Fed interest rate hikes are likely to be far more benign than investors imagine, if market history is a guide.
So says Northern Trust Asset Management’s chief investment strategist James McDonald in a new commentary guiding the storied ultra-high-net-worth wealth management firm’s clients.
McDonald argues that barring an unexpected inflation shock or the like, the Fed’s well-orchestrated plan for rate normalization should not be overly disruptive to stock and bond markets, and indeed, can be profitably exploited through what he calls a “tightening trade.”
Looking at the five tightening cycles of the past 30 years (1986, 1988, 1994, 1999 and 2004), the Northern Trust strategist shows that that the stock market has adjusted well, following an initial adjustment, rising during the 12-month period straddling the initial hike in four of the five cycles.
The one exception was the 1988 cycle, whose negative returns McDonald attributes to the October 1987 market crash rather than the fed funds cycle per se. Higher corporate earnings generally fueled the stock market rise during these cycles.
McDonald does not foresee a rate hike for some time though, noting that the data in four key areas—unemployment, inflation, wages and capacity utilization—are in the main far from signaling Fed tightening.
“Inflation is currently well below the levels at which prior rate hikes began,” he writes; moreover, the fact that the current Fed is more concerned with growth and “the durability of the recovery” over inflation risk gives markets leeway in this area.
Unemployment data also provides cushion before acting. Even though the headline unemployment has fallen from 10% to 6.2% in the past five years, McDonald says that broader measures of unemployment and a dramatically declining labor participation rate do not suggest a need for hurry on the Fed’s part.
Ditto for wage gains—which have averaged a meager 2% for all private workers in 2014. Only capacity utilization, which McDonald views as the “least impactful” measure, shows signs of maturation (as it is approaching its 30-year median) that would warrant some attention from the Fed.
In this still weak environment, “the fed funds futures market first signals a hike in July 2015 and has the hike fully priced in by October 2015,” he writes.