When the Fed stops, keep calm and carry on buying stocks

The huge outperformance of stocks over bonds this year might tempt investors to think a rebalancing is on the cards soon, but history suggests they should increase exposure to equities once the Federal Reserve's interest rate-raising cycle ends.

There is a caveat though: recession within a year of peak Fed could turn that scenario on its head, as was the case in the mid-1970s and early 2000s.

It is difficult to draw firm comparisons because the current hiking cycle which could draw to a close this year is so unique. But a look at previous cycles shows that stocks tend to increase their advantage over bonds in the 12 months after rates plateau.

This is helpful for more conservative or passive investors too – the relative strength of equities helps boost the performance of the typical '60/40' portfolio split 60% into stocks and 40% in fixed income.

Analysis by research firm YCharts looks at the hiking cycles of 1999-2000, 2004-06 and 2018-19 and how a range of sample portfolios performed in the subsequent 12 months. Even taking into account the dotcom bust and market crash following the 1999-2000 cycle, stocks still shone brighter.

The average return of a 100% equity portfolio was 12.75%, an all-bond portfolio returned 9.10%, and a 60/40 portfolio generated 11.09% on average.

The 2004-06 and 2018-19 cycles were very similar. Equities returned around 26% in the year after the Fed stopped tightening, bonds between 6-8%, and a 60/40 portfolio around 18%. As the table below shows, 1999-2000 was an anomaly.

Joe Kleven, senior marketing analyst at YCharts, notes that stocks' upward momentum often slows in the months leading up to the Fed's final rate hike, only to reaccelerate.

"Generally, stocks rise more than bonds after the Fed stops," Kleven says.

This largely holds regardless of whether the Fed stays on holds for a prolonged period of time, as it did from 2006 onwards, or quickly pivots to cutting rates, as it did in 2019.

Not only is the current cycle unlike the previous three – it is the most aggressive since the Paul Volcker era 40 years ago – markets have also gone off piste: stocks, bonds and various portfolio mixes of the two are all in the red.

Avoid recession

Stocks have barely risen since the Fed started raising rates in March 2022, but they have still outperformed bonds, particularly since both asset classes troughed late last year.

The S&P 500 is up 27% and the Nasdaq is up 37% from their troughs last October, and the NYSE FANG+ index of 'Mega Tech' stocks is up more than 90% from its November low.

The ICE BofA broad aggregate US Treasury bond index, meanwhile, is up 5% from its October low and still down around 10% from March last year.

This might indicate there is little to be gained from buying stocks here. But as investors look beyond 'peak Fed' – a terminal rate of around 5.40% by November, according to rates futures markets – the opposite may be the case.

Shelly Simpson, senior analyst at Truist, has looked at six previous Fed hiking cycles excluding the turbulent Volcker years in the early 1980s, and how stocks, bonds and a 60/40 portfolio comprising the two have performed in the year after 'peak Fed.'

The pattern is the same: the S&P 500 delivered total returns ranging between 18.9% and 34.7% after four of them, significantly outpacing bonds.

Fixed income, as measured by a broad aggregate index of US Treasury bonds, outperformed in the mid-1970s and early 2000s, returning 9.7%, and 13.1%, respectively.

Blended together, a 60/40 portfolio generated double-digit returns after five of these six cycles, including 25% in the mid-1990s. Notably, this was perhaps the only time in the Fed's history it steered the economy to a flawless 'soft landing'.

The outlier was a 1.3% decline as in the early 2000s as the dotcom crash and recession unfolded.

"A 60/40 portfolio tends to do well after a Fed pause. However, the one exception was 2001 when there was a recession. And that's the risk to the generally positive outcomes following a Fed pause," Simpson warns.

No two economic cycles, Fed reaction functions, inflationary dynamics or asset price dynamics are the same. There is really no way of knowing for sure how markets will shake out once the Fed presses down on the brakes.

But if recession is avoided, stocks may still be a good bet.

Disclaimer: The opinions expressed here are those of the author, a columnist for Reuters.