Daily Brief - Equity performance during Fed hiking cycles

Last week’s inflation print was a stunner that set alarm bells ringing across Wall Street. A fresh 40-year high in consumer price inflation set off speculations that the Federal Reserve will raise interest rates by a half-point when policy makers meet next month.

“I’d like to see 100 basis points in the bag by July 1,” James Bullard, St. Louis Fed President said in an interview with Bloomberg News. “I was already more hawkish but I have pulled up dramatically what I think the committee should do.” The question, of course, is whether this view is shared by his colleagues on the FOMC.

There are only three meetings between now and July, stoking speculation that the Fed could hike 50 bps in the upcoming March meeting. That’s a substantially more aggressive start than investors expected even a few weeks ago.

Keep calm, and carry on

So, is the equity market toast? Interestingly, no. Going back as far as the late 1980s, the market actually tends to rise rather than fall during the rate-hiking cycle. (Disclaimer: this isn’t an apples-to-apples comparison because the lengths of each cycle vary greatly.)

To be sure, it is harder to see the market producing such a performance during a period in which the economy experiences a 1970s-style inflation. The above examples serve as a good guide only assuming the inflation spike is indeed temporary.

Ok, so why don’t stocks drop during Fed rate hikes? In part, it’s because Fed hiking cycles are often preceded by market corrections. Hiking cycles are telegraphed well in advance (witness the long, drawn-out buildup into the start of this next one).

The second reason is that while markets don’t love tight monetary policy, they hate runaway inflation even more. A Fed that falls behind the curve is expected to move much more aggressively later on (to catch up). This raises investor fears of a policy error that could tip the economy into a recession.

Fed and inflation proof stocks

If you accept inflation and a more aggressive Fed as a given, what to do? TOGGLE’s analysis - featured in the Business Insider recently - highlighted 14 particularly resilient stocks in the event of a more aggressive Fed hiking path.

It’s also worth finding companies that can preserve their profit margins through pricing power. Across the economy, margins have slipped to 14.8% during the fourth quarter from 15.2% during the third quarter, according to Wells Fargo data.

Caterpillar (CAT), for one, is lucky enough to have customers flush with cash from rising commodity prices, so it’s easy to get them to pay up. Another one, CNHI Industrial (CNHI) makes farm equipment and trounced profit estimates. They can thank the soaring price of farm products like soybeans and corn for that.