Borrowed Time: Final Rate Hikes And Stock Market Rallies
Stock markets around the world have rallied after the Federal Reserve’s final interest rate hike of the economic cycle.
History suggests that the stock market rally since the last Fed rate hike on December 19, 2018 may be on borrowed time.
Over the past 30 years, stock markets around the world have rallied after the Federal Reserve (Fed) hiked interest rates for the last time in the economic cycle. The rallies have varied in length and strength, but eventually break down as the late cycle environment encounters a catalyst that ends the cycle. The market currently believes that the Fed has hiked for the final time this cycle on December 19, 2018, according to the Fed Funds Futures. The stock market rally since then appears to be on borrowed time, if we compare it to past cycles.
*So far, 12/19/2018 is date of last Fed hike. Since then the MSCI World Index has rallied 15.1% to its peak that took place about five months later on 4/30/2019.
Data covers period since inception of MSCI World Index on 12/31/1969. Past performance is no guarantee of future results.
Source: Charles Schwab, Factset and Bloomberg data as of 5/27/2019.
Let’s look back before we look to what may lie ahead. Following the last Fed rate hikes in the 1970s and early 1980s, stocks continued to slide. However, following the last rate hikes of the past 30 years, stocks rallied.
Why did the market’s reaction to the final rate hike differ before and after 1989? The main reason may be that the public learned of them. The Fed’s public communication on rate changes began to shift during Greenspan’s first year as Fed chairman in 1988. At that time, the Fed began an era of greater transparency which lead to the communication of rate changes to the public, eventually including post-meeting statements and press conferences.
Another reason may be that beginning with the Greenspan era, the Fed was less prone to raise rates during a bear market, due to a better understanding of the lags in rate movements, financial conditions, and economic impacts. In the early periods of May 1974 and May 1981, when the Fed finally stopped their rate hikes, global recessions and bear markets were already well underway. In contrast to later periods, when the Fed’s final rate hikes came before the peaks in the world’s economy and stock markets.
What to expect
Since the changes in communication and methodology made by the Fed, market peaks have come after the final rate hike—by 2 to 16 months. Following those last rate hikes, we saw further stock gains averaging 15% before an outside catalyst ended the rally. Interestingly, the MSCI World Index has posted a gain of 15% from what increasingly looks like the last Fed rate hike on December 19, 2018 to this year’s market peak about five months later on April 30, 2019.
Let’s take a look at the catalysts that ended each of the rallies that followed the Fed’s last rate hikes post-1988:
- 1989: a real estate crash in Japan in 1989 was the catalyst and was followed by Iraq’s invasion of Kuwait in 1990 which led to a doubling of oil prices which helped to tip the global economy into a recession and bear market.
- 2000: the start of the “tech wreck” when tech companies driving the market and economy were unable to meet lofty growth expectations was the catalyst causing those stocks to crash and undermine high consumer and business confidence, furthered in 2001 by the 9/11 attacks on the United States, resulting in a bear market and recession.
- 2006: a surge in oil prices to near $100 (up from $50 in mid-January) and signs of a sharply worsening U.S. housing market that had been powering the economy was the catalyst. This was furthered in 2008 by the mortgage related string of financial failures, resulting in the Great Recession and bear market.
The catalysts were different each time, but the economic environment was vulnerable in each case to a shock that brought an end to both the economic and market cycles.
We often get the question, “What is the one thing that investors should be watching for that will cause the next bear market and recession?” History shows it isn’t a cause that marks the end of the cycle, it’s a catalyst. It’s a shock that precipitates the end of the cycle due to the prevalent vulnerabilities of a mature economic cycle.
The potential shock from heightened trade tensions, given the affect they may have on confidence, capex, and financial conditions, comes at a vulnerable time for the global economy:
- The widely-watched global manufacturing Purchasing Managers’ Index has fallen for a record 12 months in a row through April, as you can see in the chart below, and the preliminary May numbers released last week continued to weaken.
Global purchasing managers’ index
Source: Charles Schwab, Factset data as of 5/27/2019.
- The composite leading index (CLI) from the Organization for Economic Cooperation and Development (OECD), a well-known economic think tank, has fallen to 99.0—a threshold that in the past has marked the line between growth and recession for the world economy, as you can see in the chart below.
World leading economic indicator and global recessions
Source: Charles Schwab, Bloomberg data as of 5/27/2019.
- The U.S. Treasury yield curve continues to flirt with inversion, as the yield on the 10 year note slips below the yield on the 3 month bill. Historically, this has acted as an indicator of a recession on the horizon.
Source: Charles Schwab, Bloomberg data as of 5/27/2019.
The rally following the Fed’s rate hike in December may be encouraging to investors, especially after the sharp decline in stocks during the fourth quarter. It also isn’t unusual. The global economy may be vulnerable to a catalyst, like an escalating trade war, which could bring an end to the rally in the stock market. Fortunately, the trend in the degree to which the world’s stock markets move in sync with each other has fallen to near the lowest level in 20 years. The lower correlation enhances the potential risk-reducing benefits of diversification. For more insights, see the recent article: Diversification: Finally Back After 20 Years.