In recent months, the actions of the U.S. Federal Reserve have played an increasingly important role in the gyrations of the U.S. economy and stock market.
You’ve probably heard it on the news: “Fed hikes interest rates by 75 basis points. Chairman Jerome Powell takes a hawkish stance toward future rate hikes.” You’ve probably seen the effects in your portfolio, with both stocks and bonds, especially growth stocks and long-term Treasurys, both losing significant value throughout 2022.
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The takeaway here is that anticipated actions of the Fed can be an important leading indicator for where markets might be headed next. Many institutional investors and traders will tailor their strategies depending on their outlook for what the Fed might do.
Investors looking to better understand the role the Fed plays in affecting the stock market and their portfolios should read on for answers to the following questions:
— What is the Federal Reserve?
— How do the markets respond to Fed actions?
— How do interest rates impact market sectors?
— How can investors respond to Fed actions?
What Is the Federal Reserve?
The Federal Reserve is the central banking system of the United States.
Comprised of 12 regional banks, the Fed is responsible for governing and conducting monetary policy, supervising and regulating financial institutions, and maintaining the overall stability of the banking and financial system by acting as a “lender of last resort.”
The Fed’s policymaking body, the Federal Open Market Committee, or FOMC, exerts influence over the economy, and by extension the stock market, via its “dual mandate,” which consists of:
1. Price stability: The Fed tries to keep inflation, as measured by annual changes in the personal consumption expenditures, or PCE, index and the consumer price index, or CPI, at a stable and low target rate of 2% over the long term.
2. Maximum employment: The Fed tries to keep the level of employment in the economy as high as sustainably possible over the long term.
How Do the Markets Respond to Fed Actions?
Juan Pablo Villamarin, senior investment advisor at Intercontinental Wealth Advisors, notes that the Fed has two primary monetary policy tools: “The main tool, and the most widely known by the public, is the fed funds rate (FFR), which is the rate that banks borrow and lend to each other overnight. Another very important tool has been open-market operations, which is essentially when the Fed buys or sells securities,” he says.
Changes in the FFR affect the overall economy by making money easier or more difficult to borrow. During the COVID-19 pandemic, the Fed stimulated the economy by dropping interest rates to all-time lows. This allowed both consumers and businesses to borrow money cheaply, allowing them to spend more and invest in growth.
The result was a V-shaped recovery, one that saw the S&P 500 rebound from a precipitous drop of more than 20% to reach all-time highs just a few months later. Numerous growth stocks posted strong returns, reaching high valuations and commanding large market capitalizations as consumers piled money into the market.
In terms of open-market operations, the Fed also implemented quantitative easing, a method of stimulating the markets by purchasing government bonds and other securities. This had the effect of providing banks with more liquidity, increasing the money supply.
Fast-forward to August 2022. After implementing a series of 25-, 50- and now 75-basis-point hikes to quell inflation, the economy has contracted significantly, posting two consecutives quarters of negative gross domestic product growth, and in so doing meeting the technical definition of a recession.
[SEE: 7 Stocks That Outperform in a Recession.]
A higher FFR means a higher cost of borrowing for businesses, which no longer have access to cheap capital for reinvestment in growth. Consumers no longer have access to low interest rates for car purchases and mortgages, causing them to spend less.
In addition, the Fed is now tapering its asset purchases, thereby dialing back the amount of economic stimulus. In effect, the Fed is hitting the breaks on economic growth in an attempt to slow the money supply and bring about increased price stability by combating inflation. This can create substantial volatility in the markets, which is what has occurred so far in 2022.
How Do Interest Rates Impact Market Sectors / Types of Stocks?
Villamarin notes that the primary result of Fed interest rate hikes on stocks is an increase in the cost of capital. “All else being equal, a higher cost of capital causes future potential profits to be worth less, and decreases investment and spending on margin by companies,” he says.
Robert Johnson, chairman and CEO at Economic Index Associates, agrees, finding that during “restrictive,” or rising-interest-rate, environments, stock returns tend to be more muted. Johnson notes that the average annual real return for stocks over a 55-year period was 13.8% in expansive periods, but only 1.7% in restrictive periods.
However, Johnson also notes that certain stock market sectors tend to be more resilient when interest rates rise. “One of the mantras you often hear is that rates are rising, and you need to favor one sector and exit another sector using a sector rotation strategy,” he says. In particular, the stocks of consumer staples, energy, financial and utilities sector companies can outperform when rates rise.
“Given that we are in a tight money environment, the research shows that it was historically best to invest in defensive sectors whose firms are less dependent upon the business cycle,” he says. “Food and beverages, household and personal care products, energy and utilities are noncyclical or defensive in nature as people need to eat, brush their teeth, and heat their homes regardless of whether the economy is strong or weak.”
Villamarin agrees, stating: “An increase of cost of capital would disproportionally affect those businesses that are more ‘cyclical’ in their demand, and ‘young’ companies that are growing and therefore need an increasing amount of capital to achieve the perceived growth.” This often includes stocks from the technology, materials and consumer cyclical sectors, and small-cap stocks.
How Can Investors Respond to Fed Actions?
One important thing to note is that investors and markets are forward looking. That is, anticipated future events are “priced in” to the current value of various assets based on investor expectations. For example, consider how markets strongly rallied the week of July 25 to July 29, after Fed Chairman Powell announced a second consecutive 75-basis-point interest rate hike.
In this case, investors were for the most part anticipating a large hike due to his previously hawkish comments. When Powell confirmed the expectation, the uncertainty faded, and markets rallied. The opposite may have happened had Powell announced a 100-point hike, which would have surprised investors and tanked markets as investors turned “risk-off.”
Brian Huckstep, chief investment officer at Advyzon Investment Management, recommends against investors trying to anticipate and trade around Fed actions. “Investors shouldn’t time the markets, as the Fed does not always take the action that investors expect, so investors can sometimes get an unexpected surprise,” he says. “Often, the market forecasts what the Fed will do and ‘front-runs’ the expected action, leading much of the impact to happen weeks ahead of the actual rate increase.”
That being said, Huckstep does recommend that investors who are less risk tolerant with shorter time horizons consider the following:
— Avoid speculative, high-volatility assets like cryptocurrencies, growth stocks and small-cap stocks.
— Hold short-term bonds in lieu of intermediate- or long-term ones.
— Underweight stocks from the technology and consumer discretionary sectors.
— Consider an allocation to cash, but don’t hold too much as inflation destroys its value.
For investors with a long time horizon, it’s worth remembering that interest rates will not rise forever. Over long periods of time, interest rate changes will normalize as the economy enters different stages of its cycle. For long-term investors, staying the course through volatility and remaining invested is the easiest, most hands-off option for dealing with Fed rate hikes.
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How Fed Decisions Impact the Stock Market originally appeared on usnews.com
Update 08/11/22: This story was published at an earlier date and has been updated with new information.
