As the financial markets wait for the Federal Reserve to pull the trigger on an interest rate hike, stock exchange traded fund investors should be assuaged knowing that higher rates typically imply strengthening economic conditions.
Last week, the S&P Composite 1500 gained 3.2% with all three of its size components rising in price, Sam Stovall, U.S. Equity Strategist for S&P Capital IQ, said in a research note. About 92% of the 142 sub-industries within the S&P 1500 have increased in price, led by precious metals, footwear and home improvement retail.
The iShares Core S&P Total US Stock Market ETF (NYSEArca: ITOT), which tracks the S&P Composite 1500 Index, has increased 3.4% over the past week and rose 2.9% over the past month.
“A driver for much of last week’s positive performance was the FOMC minutes from their October meeting, indicating that a December rate-tightening start date is still very much alive,” Stovall said. “It also implies that the U.S. economy can handle slow, but gradual, rate increases.”
Historical data also suggests that the S&P 500 Index will continue to strengthen in a rising rate environment, albeit at a slower pace.
Arranging the core personal consumption expenditures, or PCE, excluding food and energy prices into quintiles since 1960, Stovall found that when the Fed hiked rates, the S&P 500 recorded a median forward 12-month price increase of 6.8% during the lowest periods of interest rates, compared to the median 8.4% rise for all rolling 12-month periods. The S&P 500 rose 94% of the time in the following year, compared to 72% of the time for all periods.
Stovall also explained that the S&P 500 typically experienced low returns and high frequency of advances during the initial stages of rising rates as a sign of investors’ confidence in the economy.
“In a negative real-rate environment, the market increased in price more cautiously as investors worried that the economy might not be healthy enough to endure higher interest rates,” Stovall said. “Yet, it also advanced more consistently, as confidence grew that the economy was indeed not going to slip into recession.”
Over the past month, the SPDR S&P 500 ETF (NYSEArca: SPY), iShares Core S&P 500 ETF (NYSEArca: IVV) and Vanguard 500 Index (NYSEArca: VOO) have gained about 3.2%. Year-to-date, the S&P 500 ETFs rose over 3.3%.
It is only when inflation starts getting out of control and Fed is forced to aggressively hike rates that the market momentum typically falters, Stovall warned.
SPDR S&P 500 ETF
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Max Chen contributed to this article.