Hi, everyone. I'm Liz Ann Sonders, and this is the September Market Snapshot.
Today, I will explore S&P 500 performance across all 18 post-World War II Federal Reserve tightening cycles using historical data from Ned Davis Research. The record shows a consistent, if nuanced pattern. Stocks typically advanced sharply in the year before the first rate hike, but correction level drawdowns often followed within 12 months.
Now, the speed of tightening materially affected outcomes. Fast cycles—in which the Fed raised rates at nearly every FOMC meeting—generally produced deeper drawdowns and weaker first year performance. Slow cycles on the other hand, with at least one meeting between hikes on average, generated much stronger returns one year after the initial increase.
[High/low line chart for "Historically, slow cycles have had better performance" showing the performance of the S&P 500 around first Fed rate hikes compared to the speed of hikes is displayed]
Historically, the strongest S&P 500 performance followed the start of non-cycles—those with two or fewer hikes before a subsequent rate cut. Of course, it's too early to classify this next campaign because the first hike has not occurred. Still, the framework is useful. A fast cycle resembles an elevator, a fast slow cycle resembles an escalator up a little more smoothly, and a non-cycle you could think of as the stairs where reversing direction is actually easier.
[Table for "Slow cycles tend to have milder drawdowns" showing maximum drawdowns for the S&P 500 six months and one year following first Fed rate hikes is displayed]
So let's examine now maximum drawdowns during historical rate hike cycles. The S&P 500 gained an average 18% in the year before the first hike. And as of this taping, that's almost exactly its gain over the past year. Now, after the first hike, maximum drawdowns averaged 12% within six months and 14% within one year. At 12 months, fast cycled averaged a 16% drawdown versus 12% for slow cycles, and that's a gap exceeding 400 basis points. Non-cycles produced even milder declines.
Now, despite near-term volatility, recoveries historically emerged relatively quickly. Drawdowns tended to occur early after which valuations tended to stabilize, and earnings expectations ultimately adjusted to higher rates. For disciplined investors, those periods sometimes created pretty attractive accumulation opportunities, though other market forces of course remained important.
[High/low line chart for "Escalators vs. elevators" showing the change in Fed funds rate during Fed tightening cycles is displayed]
Now let's look at rate hiking cycles since 1963 by the total change in the Fed funds rate, and we used the discount rate prior to 1990. We're also going to look at the path taken to get there. So as I already mentioned, an escalator approach would be the first slow cycle in a decade if that's how the Fed approaches this one. If it ends up being a stairs approach, it would be the first non-cycle in nearly three decades.
Now, we continue to expect that any coming tightening campaign will not be aggressive, although inflation of course could alter that outlook. So far, Fed officials appear reluctant to move quickly. They seem reluctant to think they're going to need to make large hikes, even a gradual path—25 basis point increases perhaps every other meeting—could be pretty sustainable given the economy's current momentum.
[High/low line chart for "Historically, economy has been fine in slow tightening cycle" showing the performance of coincident economic indicators around the start of Fed tightening cycles compared to the speed of tightening is displayed]
Now, the coincident economic indicators, or CEI for short, those are put out monthly by The Conference Board, and they're used to assess recession or expansion conditions. That CEI has historically maintained a strong upward trajectory after slow hiking cycles began. Fast cycles by contrast tended to restrain growth. So there's this economic impact as well.
[High/low line chart for "Coincident with the better call" showing the year/year percentage change in the Leading Economic Index and Coincident Economic Index is displayed]
Now in the post-pandemic cycle, the CEI—which includes non-farm payrolls, real personal income excluding transfers, retail and manufacturing sales, and finally industrial production—those correctly signaled that the economy had avoided recession. The leading economic indicators, or LEI for short, continued to send a false contraction signal. That was what was unique about the pandemic period.
And in fact, the LEI's misfire reflected its bias toward manufacturing, housing, goods, and consumer confidence, all of which weakened as the economy reopened after the worst part of the pandemic. After that happened, the Fed tightened, and spending shifted toward services. So the LEI-CEI gap is now narrowing as leading indicators have been recovering, but investors may still want to emphasize the CEI when judging economic health, especially if tighter monetary policy again pressures LEI components.
[High/low line chart for "Payroll growth stabilizing" showing the three-month average change in nonfarm payrolls is displayed]
Now, labor market resilience has been central to CEI strength. More than six years after the pandemic began, the United States has not experienced a broad recessionary labor cycle. Now-- some industries, including technology and financial services, endured hiring recessions, and payroll growth stalled last year as near recessionary territory. Recent jobs data nevertheless show growth rebounding from that low, albeit along a weak upward trend.
[High/low line chart for "Jobs prefer the escalator" showing the performance of nonfarm payrolls around the start of Fed tightening cycles compared to the speed of tightening is displayed]
Although inflation remains the Fed's primary concern, officials also appear hesitant to tighten while job growth is recovering slowly. Today's lower payroll breakeven rate, meaning the number of payrolls on average that have to be created monthly in order for the unemployment rate to remain steady, that lower breakeven rate further complicates assessment because it's supply side forces that are playing a larger role in inflation than in past cycles.
Now, history is more favorable when tightening proceeds slowly, as we mentioned. Non-firm payroll growth remained resilient during slow cycles. Even in fast cycles, growth took slightly more than a year on average to begin slowing. Now, two years after the first hike, payroll growth averaged 1% in fast cycles versus 2-1/2% in slow cycles.
[List of "Takeaways" is displayed]
If inflation stays sticky this time, and that's a significant concern, and the labor market remains resilient, debate will ultimately center on whether the Fed chooses the elevator or the escalator or perhaps even the stairs. History favors the escalator or the stairs for both equities and economic growth. Barring a major supply shock beyond what we're experiencing already—unforecastable, but these days increasingly common—barring that additional supply stock, we expect FOMC members to prefer a gradual approach.
In sum, nearly 80 years of Fed tightening cycles show a somewhat consistent sequence. Strong pre-hike equity gains, meaningful short-term drawdowns after tightening begins, and eventual recovery. The depth and speed of declines—and the economy's growth path—depend heavily on how quickly the Fed raises rates. Understanding the character of the next cycle may help investors distinguish correction-driven volatility from structural market disruption, and identify accumulation opportunities that end up being created by monetary policy-related turbulence.
Thanks for tuning in, and I'll be back next month.
[Disclosures and Definitions are displayed]