After months of waiting, debating and telegraphing, the Federal Reserve has finally made official its plan to raise interest rates, increasing the benchmark fed funds rate by 0.25% to a target range of 0.25–0.5% — a shift from the near 0 rate and monetary stimulus that have been in place since March 2020 COVID crisis.

The Fed had, for many months, telegraphed its intention to raise rates in an effort to combat inflation that had reached multi-decade highs. Prior to this meeting (especially prior to Fed Chairman Powell's testimony in front of Congress), there were expectations for a more-aggressive 0.5% lift-off, however such expectations were faded amid the uncertainty introduced by Russia’s invasion of Ukraine. Although the Fed has assured the market they will be nimble, sensitive, or as they call it "data-dependent," Wednesday’s hike is just the first of multiple increases this year.

The Fed’s decision is in step with increased hawkishness from various central banks around the globe, including the Bank of England, which raised rates for a second time earlier this month. Let’s take a look at how Wednesday’s announcement could impact investors.

Why it’s important

When the Fed raises interest rates, the effects ripple throughout the financial system and the economy: for example, mortgages, auto loans, and credit card rates become more expensive for consumers, while businesses also pay more to borrow the money they need to fund their operations or expand. That tends to make both consumers and businesses a bit more conservative about their spending, which may then cool the economy and, hopefully, drive down the prices of goods and services.

What it may mean for markets

The flipside of this coin is the risk that attempting to tame inflation by raising rates crosses the line from cooling a too-hot economy to freezing it, which could pressure corporate earnings and ultimately stock prices. Also, higher interest rates can make fixed-income investments like bonds more appealing relative to stocks, because high-quality bonds are essentially risk-free (compared to stocks which are risk assets). Furthermore, as we have been saying for a very long time, high interest rates eats away the present value of companies that trade based on future earnings (when doing a discounted cash flow model); you clearly have seen the slaughter of non-profitable companies like Palantir (PLTR), Bionano Genomics (BNGO), Rivian (RIVN), Nio (NIO), or the flagship ARK Innovation ETFs managed by Cathy Wood.

What's fortunate is that there are obvious examples of stock market strength following Fed rate cuts, and there are fewer instances of rate increases knocking the stock market lower, at least on a longer-term basis. There’s plenty of evidence of shorter-term volatility in the wake of individual rate increases, but analysis of 13 rate-hike cycles dating back to 1954–57 (ranging in length from six months to more than five years) shows the S&P 500 gained ground in all but two of them.

The following chart highlights the S&P 500’s performance during the last two tightening cycles, 2004-2006 and 2015-2018 (rectangles):

However, none of this means investors should assume the stock market is about to embark on a new, extended bull market, the likes of which we saw in 2020. Even though this year the S&P 500 has corrected ~13% at the trough (we're now about 8% down), it still trades at an average forward P/E multiple that is higher than historical levels (see chart below).

Furthermore, there are risk factors that still have not been resolved. A correction does not end until the risk goes away or there is a solution.

Risks to keep in mind:

• Russia-Ukraine Conflict: sadly, the real worry that takes the global stock market down is not the death of civilians, but about the rippling effects from Western sanctions against Russia. Russia produces ~11 million barrels of oil per day, and when this supply is disrupted, there is less supply leading to higher oil prices, which eventually could hurt demand. The sanctions aren't going to reverse overnight even if there's a deal reached in Ukraine, and unless the world can find another source for ~11 million barrels, oil prices will remain elevated and at some point will drive the economy into a recession (see our post last week about oil and the economy here).  

• Persistent Inflation, Economy and Fed Policy: inflation in the US is running at multi-decade highs. At what point does it start to affect the consumer, reducing their ability to spend and ultimately reduce sales from companies? Also, at what extent can companies pass on higher production costs to customers? Even more complicated, the Federal Reserve's sole mission now is to focus on combatting inflation (since their other mandate of achieving minimum unemployment has been achieved). Will they make mistakes (or intentionally) create a recessionary environment to combat inflation, should it continue to persist. Act too timidly, and it may not get inflation under control; act too aggressively, and it risks derailing an economy still playing catch-up from the COVID pandemic. 

With those risks in mind, we again want to stress on diversification (not solely on an individual stock basis, but on a sector basis). Different sectors will have different reactions. Recently we've demonstrated this point endlessly by showcasing the strong gains in healthcare names like Eli Lilly and Pfizer, while pointing out the slaughters in no-profit or sky-high valuation names like Rivian (RIVN), Palantir (PLTR). We seek opportunities in high–quality, reasonably priced stocks, including financials, energy, industrials, healthcare, and consumer services. For example, financial companies, such as banks, that make money through lending which could benefit in a rising-rate environment. However, we don't want to own all banks, because there is the risk that high interest rates will drive the economy into a recession, in which case, the market would want to be in healthcare because of its secular nature.