Wall St Week Ahead: Last Fed hike tends to aid stocks, but some have doubts this time

The end of the Federal Reserve’s rate hike cycle has historically been a positive period for U.S. stocks. However, this time around, there is uncertainty surrounding the economic outlook and stretched valuations, which could potentially limit upside gains.

After raising borrowing costs by 525 basis points since March 2022, the Federal Reserve is expected to keep rates unchanged at its upcoming meeting. Many investors believe that this will mark the end of the central bank’s aggressive monetary policy tightening cycle.

If this is the case, stocks could see further gains. Historical analysis shows that after the Fed’s past six periods of credit tightening, the S&P 500 rose an average of 13% from the final rate hike to the first cut in the following cycle.

However, some investors are taking a more cautious stance, anticipating that higher rates will eventually tighten economic conditions and lead to a downturn. The S&P 500 has already seen a significant increase of over 16% this year, supported in part by a resilient U.S. economy in the face of higher interest rates.

Brent Schutte, Chief Investment Officer at Northwestern Mutual Wealth Management Company, states that while the market may initially react positively to the end of the Fed rate hike cycle, the direction of stocks will ultimately be determined by the economy. Schutte’s firm currently favors fixed income over equities.

While a recession is seen as unlikely in 2023, some market participants still anticipate a potential slowdown next year. One concerning signal is the inverted Treasury yield curve, which has been a precursor to past downturns.

The Federal Reserve will release its policy statement on Wednesday, with a 97% chance that rates will remain unchanged, according to the CME FedWatch Tool. Traders believe there is a roughly two-thirds chance that rates will stay unchanged in November, and a 60% chance for December.

Some market participants anticipate that the Federal Reserve may need to raise rates further in order to curb inflation. However, if benign inflation data continues, it is possible that the quarter-point increase in July marked the end of the rate tightening cycle that disrupted asset prices last year.

If the conclusion on Wall Street is that the Fed has indeed finished its rate tightening program, this could provide support for stocks or potentially give them an additional boost. Sam Stovall, Chief Investment Strategist at CFRA, explains that historically, the market has performed well after the Fed ends its rate hike cycle.

Investors are also trying to determine when the Federal Reserve will start easing monetary policy. Historical analysis shows that the Fed typically cuts rates around nine months after its last rate increase, with the S&P 500 gaining an average of 6.5% in the following six months.

There is currently a small chance of a rate cut as early as the Fed’s January meeting, with expectations for a cut at around 35% in May, according to CME data.

Challenges remain for the stock market, even if the Fed is finished with rate hikes. Analysts at Oxford Economics predict further downside for global earnings, noting that stocks have historically delivered weaker returns following the final rate hike when it coincides with an earnings per share downturn.

Concerns over stock valuations are also prevalent, as valuations have increased significantly this year. The S&P 500 is currently trading at approximately 19 times forward 12-month earnings estimates, compared to 17 times at the beginning of the year and the long-term average of 15.6 times.

The rise in bond yields also poses a threat to equity valuations, as higher yields make fixed income investments more attractive compared to stocks. The yield on the 10-year Treasury is close to 15-year highs.

While the end of the Fed rate hike cycle may initially be cause for celebration, some experts question the sustainability of stock market gains given the current valuations relative to bonds.

Overall, the conclusion of the Federal Reserve’s rate hike cycle typically bodes well for U.S. stocks. However, uncertain economic conditions and stretched valuations could potentially limit upside gains this time around. Investors will be closely watching the Federal Reserve’s upcoming meeting for signals on future monetary policy decisions.