Last week’s Consumer Price Index reaffirmed that inflation remains elevated, with the broad inflation measure increasing 3.4% year over year. Core inflation, which excludes the more volatile food and energy categories, rose 2.4% from a year ago, remaining above the Federal Reserve’s (Fed) 2% target.
As a result, markets are anticipating another potential 0.25% Fed rate hike this Wednesday, raising an important question for investors: What could higher interest rates mean for stocks?
History provides some useful perspective
A rate hike by itself does not necessarily derail a positive stock market environment. Looking at the six Fed tightening cycles since 1994, stocks often experienced some short-term turbulence following the first hike but generally recovered as investors refocused on economic growth and corporate earnings. Over the 12 months following an initial rate hike, the S&P 500 Index posted an average gain of 6.7% and a median gain of 10.7%, although past performance does not guarantee future results.
Why Today May Be Different From 2022
The last interest-rate hiking cycle began in March 2022 and coincided with a significant downturn in both stock and bond markets. However, today’s economic backdrop looks considerably different from the environment investors faced at that time.
Economic growth remains solid, labor markets remain healthy, and inflation is well below its 2022 peak. Strong household balance sheets and the large number of homeowners who locked in low, fixed-rate mortgages have also made consumers less sensitive to higher interest rates. At the same time, investment related to artificial intelligence and data center construction continues to provide an important tailwind for economic growth.
What Should Investors Take Away?
Higher rates could bring periods of market volatility, particularly if Treasury yields rise quickly. However, the greater concern for stocks would likely be a combination of higher interest rates and increasing recession risk.
For now, recession risks remain relatively low given the supportive economic fundamentals outlined above. This suggests higher rates may represent more of a headwind for markets rather than something that necessarily brings the current bull market to an end.
The Bottom Line
Markets rarely move in a straight line, and changing Fed policy can create uncertainty. Rather than focusing too heavily on the Fed’s next move, we believe it remains important to maintain perspective, stay diversified, and keep investment decisions aligned with your long-term financial goals.
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