What history tells us about asset-class performance between the last rate hike and the first cut
Published Apr 14, 2023 • 4 minute read
Federal Reserve Board Chair Jerome Powell. Photo by REUTERS/Leah Millis By David Rosenberg and Marius Jongstra
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Access articles from across Canada with one account. Share your thoughts and join the conversation in the comments. Enjoy additional articles per month. Get email updates from your favourite authors. Whether or not the United States Federal Reserve hikes again in early May, it is becoming very clear at this point that we are at the end of what will have proven to have been the most pernicious tightening cycle since the early 1980s. Rather apropos considering that Fed chair Jay Powell has spent every opportunity this past year comparing himself to the master inflation dragon slayer, Paul Volcker. And even he paused. Not just paused, but also pivoted.
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We believe that everything moves in cycles, as in the economy, interest rates and financial markets, but we thought it prudent to delve into the history books to see what the investing environment looks like during the Fed pause period that follows a tightening cycle.
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Article content In a nutshell, the historical record is clear that it pays to maintain a bias towards U.S. Treasuries, tilt equity exposure to defensives/rate-sensitive equity sectors, and limit commodities to energy over base metals.
So, what does history tell us about asset-class performance in the period between the last rate hike and the first cut? To answer this question, we went back to prior periods, evaluating how various parts of the market did (on a median basis) with 50 years of data on hand.
Play defence Beginning with equities, it is unsurprising to see stocks hold in well as rate hikes come to an end, but growth and earnings have yet to weaken to the point where the cutting cycle begins (S&P 500 median gain of 7.5 per cent). At the sector level, however, it is not the typical “growth areas” of the market that are leaders, but rather the defensives (consumer staples: 11.2 per cent; utilities: 10.1 per cent) and rate-sensitives (real estate: 16.5 per cent; financials: 13 per cent).
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Article content With the benefit of hindsight, this makes sense. Investors realize the cycle is in the late innings and recession pressures intensify (it is the reason why the Fed is pausing that takes over rather than the pause itself), which implies a shift in the portfolio strategy to play defence while the areas most negatively affected by rising interest rates in the tightening cycle get a reprieve.
When it comes to fixed income, yields fall across the Treasury curve, led by the front end (the two-year yield falling 53 basis points; 30-year down 27 basis points) as Fed expectations are removed from the equation and the yield curve begins to re-steepen. Meanwhile, corporate credit underperforms during this late-cycle period with spreads widening.
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Article content Due to the nature of how duration influences bond prices, the long end of the curve experiences a smaller median decline in yields, but the total return for investors in the 30-year vastly outperforms those for the two-year (8.6 per cent for the former and 4.1 per cent for the latter). More importantly, the median total return of the long bond matches that of the S&P 500. Adjusted for volatility and potential capital loss, this means bonds are more compelling than stocks on a risk-adjusted basis in this “policy pause” part of the rates cycle.
Greenback gains On the currency front, it may seem surprising to see that the U.S. dollar rallies in this phase (DXY dollar index has a median gain of 2.1 per cent), but that is because rising recession risks go global, and the greenback emerges as a safe haven. And the combination of dollar strength and a cyclical slowdown tends to undercut the commodity complex — the Commodity Research Bureau index declining by roughly two per cent in this phase.
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Article content Drilling down further, we find that base metals are hit the hardest (-3.1 per cent) and oil is the star performer. Gold has shown to be flat during this pause, as the beneficial impact from dampened real interest rates is offset by the strength we tend to see in the U.S. dollar. Best to wait for the actual rate cuts, which follow the pause just as surely as the pause follows the tightening cycle.
White-collar jobs will be painful casualty of AI What comes after a peak yield curve inversion? Nothing good Fed should have followed Bank of Canada’s lead Bottom line: even though history rhymes instead of repeats, looking at past episodes and discovering recurring patterns is always a prudent strategy. In this case, by assessing the various asset classes and how they perform between the last rate hike and the first cut. Generally speaking, equities do fine, but with a defensive/rates bias and underperform Treasuries in terms of risk for reward. The yield curve steepens. Credit spreads widen. Commodities are in the penalty box, outside of the oil complex. And the dollar tends to benefit from safe-haven flows.
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Interestingly, with Treasuries gaining across all maturities, as the curve begins to re-steepen, the long end provides equity-like returns but with safe-haven qualities, making it more attractive on a comparative basis and emphasizing the benefits of increasing bond exposure over equities in the portfolio at this time.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Marius Jongstra is a senior economist and strategist there. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.
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