Late last month, the Federal Reserve (Fed) reminded everyone that a 2015 rate hike is still a possibility. That said, with the economy decelerating, emerging markets still a risk and inflation expectations stuck near multi-year lows, a December hike is by no means assured.
Should the Fed demure and recent seasonal patterns persist, i.e. first-quarter economic weakness, it’s entirely possible that an initial hike gets pushed out until the second quarter of next year. This possibility raises the question: What difference, if any, will a delayed hike make for stocks?
As I discussed earlier this year, in the Market Perspectives paper No Exit: Can the Fed Normalize Rates-And How Will It Impact Stocks?, an initial rate hike has historically been a temporary headwind for stocks; it has rarely been a harbinger of a bear market.
Whether or not the Fed decides to raise rates in December, January, or April is unlikely to be the primary determinant of how the broader U.S. market performs. However, there are certain segments of the market that are more sensitive to changes in monetary policy and may benefit from any delay by the Fed
- Small Caps. As I’ve discussed in the past, small caps have struggled this year despite optimism that a strong dollar would favor this style. The culprit: rising real rates, which tend to negatively impact small cap valuations more than those of large cap firms, as Bloomberg data show. Historically, small cap relative performance has been strongest when short-term rates–those controlled by the Fed–are falling. There is also a difference between a flat and rising rate environment. According to data accessible via Bloomberg, since 1980 quarterly S&P 500 and Russell 2000 price returns have been roughly equal when rates are flat. In contrast, when rates are rising, large cap stocks outperform roughly 65 percent of the time. As such, a delay by the Fed would suggest a more balanced environment for small cap and large cap returns.
- Emerging Markets (EMs). Historically EMs have struggled when rates are rising. Tighter monetary conditions can hurt EM stocks in a number of ways. In particular, such conditions generally raise the cost to borrow in dollars, pulling capital back into the United States from overseas and negatively impacting investor appetite for riskier securities. Since 1988 the MSCI EM Index has underperformed the S&P 500 roughly 75 percent of the time (on a quarterly basis) when the Fed Funds rate was rising. The average underperformance was nearly 5 percent. In contrast, relative returns were flat, on average, during periods when the Fed Funds rate was steady (source: Bloomberg data). A Fed that stays on hold, or raises rates at a very gradual pace, should mitigate some of the pressure on EMs.
To be clear, neither asset class typically performs brilliantly simply because short-term rates are stable. But stable rates could mean a less challenging environment for both small cap and EM stocks.