How Should We Invest When the Fed Stops Raising Rates?

When it comes to the impact of the end of interest rate hikes on assets, it is essentially transmitted through the downward trend in financing costs. However, the interest rate cycle is also the result of the economic cycle. By analyzing the experience of several rounds of interest rate hikes over the past few decades, there are some rules:

Regardless of whether it is due to the end of interest rate hikes itself or the macroeconomic and market weakness that often follows, the high point of long-term US bond yields always occurs before the end of the interest rate hike.

Historical experience since the 1990s shows that the peak of the 10-year US bond yield generally leads the end of the interest rate hike by 1-3 months. However, there are significant differences in subsequent trends. Most of the time, they drop rapidly, but there are exceptions. For example, after the end of the interest rate hike in 2006, the 10-year US bond yield fell from 5.2% at the end of June to 4.4% at the beginning of December, but rose again in 2007 and reached a new high of 5.3% in mid-year until the start of the interest rate cut in 2007 when it fell significantly.

There is often a small market correction before the end of the interest rate hike cycle (in some cases, market correction is also the reason for the end of the interest rate hike, such as the end of 2018). However, once the interest rate hike ends, the market usually rebounds and recovers, with emerging markets mostly outperforming.

However, the rebound cannot be simply regarded as the beginning of a reversal, and must be combined with specific fundamental conditions. Stopping rate hikes may also mean that there are problems with the economy or the market. If this problem cannot be solved by stopping the interest rate hike alone, the market will face even greater pressure later, forcing the Fed to turn to interest rate cuts. This is also the reason why the market often falls sharply in the early stages of an interest rate cut. For other markets outside the US stock market, the Fed's monetary policy is an exogenous variable, so whether the market rebound can continue depends on how much the subsequent endogenous fundamentals have been restored. A typical case is the beginning of 2019. After the Fed decided to stop raising interest rates, US stocks and Chinese H shares rebounded quickly, but the overall index of Hong Kong stocks turned into two-quarters of turbulence after April, even though the Fed had entered an interest-rate cut cycle in July.

After interest rate hikes end, assets more sensitive to interest rates such as growth stocks tend to perform well. Since the 1990s, one month after the end of interest rate hikes, the Nasdaq as a whole has outperformed the S&P 500, and the growth style performs better than value style.

Looking at the current situation, investors overweighted the pharmaceutical, technology, and telecommunications industries, and low-allocated to utilities, materials, and non-essentials. It basically reflects one theme, that investors hold a relatively pessimistic view of the future economy and believe that interest rates will not decrease significantly. This is because defensive industries such as pharmaceuticals and telecommunications are less sensitive to the economy and have more defensive performance. The technology sector should still focus on major technology companies. Overall, these have a better ability to withstand an economic downturn and their idle cash can generate higher returns in a high-interest-rate environment.

In contrast, in the under-allocated industries, non-essentials and materials are obviously more sensitive to the economy, and if the economy deteriorates in the future, they both have significant downside risks. Although public utilities also have defensiveness, their debt ratio is usually high, which is not ideal in a high-interest-rate environment. This represents investors’ expectations that interest rates will not decline too quickly. In addition, the advantage of public utilities is dividends. Now you can directly buy risk-free assets such as US Treasury bonds, which will reduce the attractiveness of dividend-paying stocks.

US Bonds: The general trend is for US bond yields to decline, but if the market spontaneously trades with looser financial conditions, it may in turn strengthen expectations of further interest rate hikes by the Fed or provide support for growth. In the short term, if US bond yields rise again, investors can increase holdings, and if they drop sharply, temporarily stop taking profit, and waiting for a better opportunity will be good.

According to the latest data from a survey of Bank of America fund managers, fund managers are investing heavily in bonds and the proportion of over-allocation has reached a new high since 2009. The change is due to the expectation that inflation and bond yields will continue to fall until 2024. In the survey, fund managers' idea of interest rate peaking has come to the peak of this interest rate cycle when everyone thinks that there will be no more interest rate hikes. Buying bonds now can lock in high returns, and also enjoy the dividend if the Fed cuts interest rates next year.

US Stocks: In the short term, stocks were boosted by slowing interest rates and recovered, but may remain volatile; according to current expectations, the consensus market expects S&P 500 Q3 earnings growth to rise from -4% in Q2 to 3.6%, while Nasdaq remains almost flat at 15%. From the perspective of earnings adjustment sentiment, the upward momentum of earnings adjustments has slowed down recently. Therefore, it is not recommended to chase after high prices.

Emerging Markets Stocks: Pay attention to rebounding sectors with high resilience and interest rate sensitivity sectors, and adopt a general strategy of "buying cheap". For example, at the current valuation level, it is not difficult for Hong Kong stocks to rebound due to external interest rate easing and internal policies that effectively address the situation, especially for oversold, high-resilience or interest-rate-sensitive sectors such as biotechnology, technology hardware, new energy, and the internet. However, longer-term and sustained gains depend not only on the external environment but also on continued policy efforts.