By Benedek Vörös
Although higher rates are generally seen as negative for risk assets, the initial stages of a monetary tightening cycle have not been disastrous for the US stock market historically.
However, while the overall market may muddle through just fine, the same may not be true for the different sectors and factors that compose a broad benchmark like the S&P 500®.
The stretch of history for which we have full data on the S&P 500’s various GICS® sectors and factor indices is around three decades’ long. However, the rate cycle moves slowly, with only four occasions of “liftoff” since 1994.
We are presented not so much with a sample as a series of case studies. Nonetheless, history suggests a few top-level conclusions that sector- and factor-based equity investors might draw.
Turning first to sectors, Exhibit 1 shows the average excess returns of S&P 500 sectors in years when a rate hike cycle started and in other years.
Exhibit 1 suggests three distinct clusters of sectors based on their historical reaction to rate hikes.
- “Rate hike agnostics” – The performances of Energy, Industrials, Materials, and Consumer Discretionary were similar in years of first hikes and other years.
- “Rate hike underperformers” – Consumer Staples, Health Care, Financials, and Utilities underperformed the S&P 500 in the years when the Fed started raising rates. Utilities was the worst performing, confirming the sector’s “bond proxy” characteristics. Financials, which by convention is assumed to benefit from higher rates, also underperformed on average, but a look at the data reveals a major idiosyncratic event: in 1999, the S&P 500 was pulled up by Information Technology, and out-of-fashion Financials underperformed the index by 17%.
- “Rate hike beneficiaries” – This cohort contains Real Estate (established as a separate sector in 2016, therefore experiencing just two rate hike cycles) and Information Technology. Like Financials, Information Technology’s excess returns were greatly influenced by the 1999 dot-com bubble, during which year it outperformed the S&P 500 by 58%. If we take out 1999, the sector’s average excess return drops to just 5% in the other three calendar years when a rate hike cycle commenced.
Turning to factors, Exhibit 2 shows the average excess returns of S&P 500 factors in years when a rate hike cycle started and in other years.
In the case of factors, the “rate hike agnostic” group appears to be lacking in representatives, so we divide it into just two cohorts.
- “Rate hike winners” – This group contains Momentum, High Beta, and Growth. All three factors’ gains can be ascribed to 1999, when they had a large tilt towards Information Technology and consequently outperformed the benchmark by 27%, 32%, and 7%, respectively. If we remove 1999 from the sample, the average excess return in the year of a first rate hike drops to 1.1%, -5.8%, and 0.5% for Momentum, High Beta, and Growth, respectively.
- “Rate hike underperformers” – Just as for “winners,” 1999 greatly influenced this group’s excess returns. The three factors that lagged the most on average, Low Volatility, Dividend Aristocrats®and Quality, underperformed the S&P 500 by 29%, 26%, and 14%, respectively, in 1999. Excluding 1999, both Low Volatility and Dividend Aristocrats would have outperformed the S&P 500 in the three other years in which a rate hike cycle started (by 2% and 1%, respectively), while Quality would have matched the return of the benchmark.
The overall takeaway from our analysis is that for both sectors and factors, the fact of a rate hike often played second fiddle to exogenous forces, such as a speculative bubble in dot-com stocks.
While the Federal Open Market Committee’s activities are no doubt of importance to the relative returns of factors and sectors, an excessive focus on monetary policy at the expense of the broader economic and market environment could lead market participants astray when appraising prospects for the year ahead.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.