Why some investors are doubtful about last Fed rise supporting stocks

An uncertain economic outlook and stretched valuations could dampen market sentiment

On the floor of the New York Stock Exchange. The S&P 500 is already up more than 16 per cent this year. AFP

The end of the Federal Reserve's rate rise cycle has generally been a good time to own US stocks, but an uncertain economic outlook and stretched valuations could dampen upside this time around.

After raising borrowing costs by 525 basis points since March 2022, the US central bank is widely expected to keep rates unchanged at the conclusion of its meeting next week.

Many investors believe that policymakers are unlikely to raise rates any further, bringing an end to the central bank's most aggressive monetary policy tightening cycle in decades.

If they are right, stocks could be poised for more gains. After the Fed's past six periods of credit tightening, the S&P 500 rose an average of 13 per cent from the final rate rise to the first cut in the following cycle, an analysis by financial research company CFRA showed.

Investors with a more bearish view, however, say it is only a matter of time before higher rates tighten economic conditions and bring a downturn.

The S&P 500 is already up more than 16 per cent this year, aided in part by a US economy that has been resilient as interest rates increased.

“The market will probably cheer it a bit if it is the end of the Fed rate hike cycle,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management Company.

However, “I don't think the economy is going to stay out of a recession and that is going to be what ultimately decides the direction of stocks”, said Mr Schutte, whose company favours fixed income over equities.

Although most investors believe a recession is unlikely in 2023, for some a slowdown next year remains a possibility.

One worrying recession signal has been the inverted Treasury yield curve, a market phenomenon that has preceded past downturns.

The Fed will give its policy statement on Wednesday, with odds at 97 per cent that it will keep rates unchanged, according to the CME FedWatch Tool, which tracks bets on futures tied to the central bank's policy rate.

Traders see a roughly two-out-of three chance of the Fed leaving rates unchanged in November, CME's data showed.

Odds for December show about a 60 per cent chance rates of rates staying at current levels.

Fed Chairman Jerome Powell said last month that the central bank may need to raise rates further to cool inflation, promising to move carefully at meetings.

More of the kind of generally benign inflation data that has come over the past few months, however, could mean the Fed's quarter-point increase in July was the last in a cycle that shook asset prices last year.

“If Wall Street comes to the conclusion that the Fed has ended its rate tightening programme, that would at least offer support if not give [stocks] an additional catalyst to keep working higher,” said Sam Stovall, CFRA's chief investment strategist.

Investors are also attempting to gauge when the Fed will begin easing monetary policy.

CFRA found that the Fed has tended to cut rates an average of nine months after its last rate increase, with the S&P 500 gaining an average of 6.5 per cent in the six months following the cut.

Investors are pricing in a small chance of a cut as early as the Fed's January meeting, with expectations of a cut at about 35 per cent for May, according to the CME data.

Some investors, however, see challenges for the stock market even if the Fed is done with increases.

Analysts at Oxford Economics forecast further downside for global earnings, noting that stocks “have typically delivered far weaker returns following the final Fed rate hike when it has coincided with an EPS downturn”.

Oxford and other investors are also wary of stock valuations, which have ballooned this year.

The S&P 500 is trading at about 19 times forward 12-month earnings estimates versus 17 times at the start of the year and its long-term average of 15.6 times, according to LSEG Datastream.

Equity valuations are also threatened by the rise in bond yields, which has increased the attraction of fixed income as an investment alternative to stocks.

The yield on the 10-year Treasury is close to more than 15-year highs.

“If [the Fed] came out and said 'we're done,' yeah I do think that is probably cause for some celebration,” said Jack Ablin, chief investment officer at Cresset Capital.

“But I'm not sure how sustainable it would be given where stocks are valued relative to bonds already.”