By Stuart Robertson, Portfolio Manager, The Partners Group

Concerned about the Fed raising interest rates? Listen to John Woolley, Managing Director of Wealth Management, and Portfolio Manager Stuart Robertson talk it through, and then read their commentary below.

After months of hearing how the Federal Reserve will attempt to rein in inflation, we have seen some clarity to their policy path. On March 16, 2022, the Federal Reserve raised its benchmark Fed Funds Rate by 25 basis points (bps). There is a mantra in markets that you “don’t fight the Fed “ (meaning, invest more aggressively when rates are low and conservatively when rates are increasing). And yet, just because the “punchbowl” of easy money policy is being removed doesn’t mean the stock market party is over. Because of this, we felt it prudent to discuss the interest rates and their effects on the economy and markets.

The Fed Reserve Board (“the Fed”) is the steward of monetary policy in the U.S. The Fed has many responsibilities from supervising the banking system to setting interest rate policies. With respect to the economy, the Fed has a dual mandate: to maximize employment and provide price stability. Price stability has been the main focus lately, as inflation has increased sharply over the past few months.

The tool that the Fed uses to rein in inflation is setting interest rates, by establishing the Fed Funds Rate which is the average interest rate that banks pay for overnight borrowing. And while this is the only rate over which the Fed has direct control, this one simple rate has ripple effects on everything from consumer interest rates to credit card rates. When the Fed sets rates low, it’s encouraging growth and higher inflation. And when they raise rates, they are looking to restrict inflation and often with the outcome of lower growth.

Exhibit 1. S&P 500 Annualized Returns during Hiking Cycles

Source: FactSet Research Systems

So, does investing more conservatively while the Fed raises rates make sense? Not really. Generally, rising rates have been a plus for equity markets in the initial phases of a rate-hike cycle.

According to FactSet, since 1955 the S&P 500 has returned an average of 7.5% in the first year after the Fed begins to increase interest rates. In fact, in the past three cycles where the Fed increased interest rates, the S&P 500 rose on average 9.6% annualized during those periods. The only period which saw a negative annualized rate of return was from March 1972 to July 1974. The bond market is another story, though. Bonds have an inverse relationship with rising rates, and when the cost of borrowing money rises, the prices of bonds usually fall. To mitigate this, it’s prudent to lower a bond portfolio’s duration (think average maturity)—or its sensitivity to rising rates.

Exhibit 2. Fed Funds Target from 1971–2022

Source: FactSet Research Systems

So how do rising rates effect the economy? First, it’s important to note that the stock market is not the economy. The market can be viewed as a forward indicator of the economy—of corporate profits, more specifically. Interestingly, rising interest rates are not a sign of a weak economy but of a strong economy. Higher rates usually accompany conditions of lower unemployment, improving wage growth, and rising inflation—all signs we are seeing today. Higher rates can result in a recession—but it’s not an immediate phenomenon. Because the Fed hikes rates gradually, it takes time (often 12–18 months) for policy to become a drag on the economy.

And while we expect rates to strongly increase this year, interest rates are still quite low relative to average rates in the past. Consider that since 1971, the average Fed Funds rate target has been 4.95%. If the Fed hikes rates at all seven of their remaining meetings by 50 bps we will have a Fed Funds Rate of just 3.75%—still well below the historical long-term average. There are far more drivers of the stock market returns than Fed policy and higher rates, as we’ve seen the stock market digest multiple 25–50 bps point hikes over the years.

At The Partners Group, we continue to take a disciplined approach to managing client portfolios. We don’t let mantras or fear dictate the management of our strategies. Instead, we follow our data and lean on the collective expertise of our Investment Committee. We have had periods of higher rates and higher inflation in the past, yet markets are resilient; we believe higher rates should not be feared. We will continue to monitor our indicators and adjust portfolios should those change.

CONTACT THE WEALTH MANAGEMENT TEAM