Put differently, markets characterized by multiple expansion—in other words, when investors are paying more per dollar of earnings—are more vulnerable to a change in monetary conditions. The fact that U.S. equity multiples have been consistently rising since 2011 suggests that markets are at greater risk for at least a modest correction following a rate hike. In addition, one area of the market – namely small caps – may be particularly vulnerable and warrants caution. Historically, small caps have been more sensitive than large caps to the reduction in returns associated with monetary tightening.
To be sure, this will be a very different tightening cycle than previous instances. Rates have never been this low for this long, and the Fed will be forced to adopt a new set of monetary tools to wind down its bloated balance sheet.
As a result, the equity market’s reaction to tightening is more unpredictable than it has ever been, a fact likely to increase anxiety and uncertainty throughout the cycle. Still, a normalization in U.S. monetary policy is unlikely to herald a catastrophe.
Starting this fall, investors should, at the very least, expect more volatility and a heightened likelihood of a correction. For more on the likely market impact of a Fed rate hike, read my full Market Perspectives paper, and be sure to check out this BlackRock Investment Institute paper too.
Sources: Bloomberg, BlackRock
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.