By Lewis Krauskopf
NEW YORK, Sept 24 (Reuters) - History suggests US stocks are poised for weakness as the Federal Reserve starts raising interest rates, but investors trying to gauge the ultimate market fallout are focused on how aggressively the central bank hikes and the economy's response.
In an effort to cool off persistently high inflation, the Fed last week increased its benchmark rate for the first time since 2023, which should increase borrowing costs. The US central bank signaled it expects
to follow the quarter-percentage-point hike with another increase by the end of the year. Investors are factoring in more hikes in 2027.
"Our bottom line is (whether) the Fed's actions have an impact on the market's expectations for either economic growth or corporate profit growth," said David Lefkowitz, head of US equities at UBS Global Wealth Management. "We don't think the Fed has to hike that much. This is where the debate I think is going to be for the market: How much does the Fed have to hike?"
The benchmark S&P 500 has gained more than 12% so far this year, and was hovering near record levels on Wednesday. Robust corporate profits have outweighed risks including spiking oil prices amid the Middle East conflict, rising bond yields and the hawkish turn by the Fed.
But investors are bracing for potential downside in the near term. The S&P 500 has logged a 2.6% decline, on a median basis, three months following the first hike in a cycle, according to data from LPL Financial, which examined six cycles since the Fed began announcing outcomes of its meetings in 1994.
In these periods, the index endured a "meaningful drawdown" mostly not long after the initial hike, according to Lori Calvasina, head of US equity strategy at RBC Capital Markets. In five of the cycles, declines from S&P 500 peak levels ranged from 8% to 14%, with the lows occurring from one month to three and a half months after the hike, RBC said.
"The fact that we are starting this new phase keeps us vigilant for a near-term ...garden variety pullback of 5-10% in the S&P 500," Calvasina said in a note on Friday.
2022 MARKET SLIDE LINGERS
One exception, fresh in the minds of investors, is the hiking cycle that began in March 2022, when stocks eventually endured a bear market. That year, the S&P 500 dropped 25% from its peak, hitting its low about seven months after the first hike.
Calvasina and other market analysts draw distinctions between the 2022 environment and other periods, including the current one. That year involved fears of a recession and a particularly aggressive hiking cycle, analysts said.
"It was the magnitude of hikes in 2022 that spooked the market," said Sam Stovall, chief investment strategist at CFRA.
The current hiking cycle is expected to be relatively short and shallow. Fed funds futures as of Wednesday suggested the rate will peak at around 4.8% in a little over a year, for total hiking of just over 100 basis points, or one percentage point, according to LSEG data. Since 1983, the average rate hike cycle has lasted just under two years, with rates rising 320 basis points, according to Jane Gibbons, an equity strategist at Jefferies. In the 2022-2023 cycle, the Fed hiked by 525 basis points.
The current hiking trajectory "feels like a mid-cycle adjustment that still can be absorbed from a growth perspective and hopefully labor market perspective," said Mona Mahajan, head of investment strategy at Edward Jones.
STOCKS TEND TO RECOVER
After initial slides during past hiking cycles, stocks have tended to recover relatively quickly. A year after the first rate hike, the S&P 500 was 6.8% higher, on a median basis, with the index positive a year out in each cycle except for 2022-2023, LPL said.
"Historically, stocks do get a little jittery initially after the hiking cycles start," said Jeffrey Buchbinder, chief equity strategist at LPL Financial. "Then they tend to calm down and return to the fundamentals of economic and earnings growth."
Higher rates can unearth or contribute to vulnerabilities in the economy that had not been evident. Although stocks were higher a year after the start of the 1999-2000 cycle, the rate hikes during that time could have exacerbated the severe market slide once the Internet bubble burst in the early 2000s, investors said.
With the latest hike, the market's recent modest performance could mitigate any declines. The index was little changed in the three months prior to last week's move, compared to average gains of 4.2% in the three months ahead of initial hikes historically, said Jeff Schulze, head investment strategist at the Franklin Templeton Institute.
"I think the market is poised to continue to melt higher into a very strong seasonally fourth quarter," Schulze said.
UBS' Lefkowitz plans to closely watch the ISM manufacturing index, in particular the new orders component, as he looks at economic indicators to gauge the stock-market fallout from the hiking cycle.
"The market is just going to be much more sensitive to both the growth and the inflation data," he said.
(Reporting by Lewis Krauskopf, editing by Colin Barr and David Gregorio)
