What do Fed rate hikes mean for stock markets?

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JU.S. stocks enjoyed an overnight relief rally from the Fed’s expected rate hike, with the tech-heavy Nasdaq index jumping 3.77%, following a 3% recovery the previous day. Risky assets bounced off the Fed’s decision as a 25 basis point hike was widely expected, and the projection for continued monetary policy was not as aggressive as previously estimated. In fact, stock markets have risen as interest rates have risen in all past monetary tightening cycles, which is contrary to what mainstream theory suggests.

Nasdaq Composite vs Fed Funds Compound Interest Rate (2009-2022)

What is the policy of the Fed?

The Fed raised interest rates by 25 basis points for the first time since 2018 and has scheduled six more rate hikes this year. The committee mentioned that it plans to start reducing its balance sheet by $8.9 trillion at the next meeting, but did not give details on the timing and size while explaining that the invasion of the Ukraine by Russia meant greater uncertainty for the US economy.

Fed members see inflation at 4.3% this year, 2.3% in 2024, higher than expected. The committee lowered the outlook for economic growth to 2.8% from 4% in 2022.

What are the key elements driving stock market performance?

From a macro perspective, stock market performance is based on long-term economic growth and company earnings. Based on the two charts below, the S&P 500 has a positive correlation with US GDP growth. During the 3 recent recessions that occurred in early 2000, 2008 and 2020, stock markets all saw declines, while the economy returned to positive growth, stock markets also saw gains.

In the micro perspective, the valuation of a company’s stock is based on the company’s growth, dividend, and returns. Higher interest rates will technically reduce the future value of money due to reduced supply, but that doesn’t necessarily mean that a cycle of monetary tightening will prevent business growth. This is why growth stocks have outperformed cyclical sectors due to mega cap and rapid earnings growth, in which we can see technology frontrunners, such as electric car makers, chip makers and social media, are part of this group.

Current stock market concerns

The risks facing equity markets right now are high inflation and an aggressive pace of monetary tightening. Supply chain disruptions, labor shortages, soaring energy and commodity costs are all contributing to soaring inflation in the post-pandemic era. Consumer affordability becomes a serious concern when wage growth does not keep pace with consumer price increases. On the other hand, rapid rate hikes will hurt liquidity and reduce demand, which will not solve the supply side of the problems driving up inflation, all of which point to slowing economic growth.

To conclude, when people worry about whether there will be an inflation-induced recession, a slowdown in economic growth should be considered first, which in turn would weaken the growth velocity of stock markets. . Investors should closely monitor the performance of companies in the first quarter and assess the degree of impact of a tightening of monetary policy to develop investment strategies.

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