US economy, Markets What happens after the Fed pauses?

In the table above, we show S&P 500 performance after the Fed completed prior rate hiking campaigns, along with other key metrics.

We would make a few observations:

• Stocks tend to rise once the Fed is done hiking rates. But we should bear in mind that stocks usually rise about 9% on average over any 12- month horizon. So the returns after a Fed pause look no different than normal.
• However, the “hit rate” is lower than average. Stocks generate a positive return 60% of the time after a Fed pause, slightly lower than the average of 75% over any 12-month period.
• In addition, valuations today are higher than average at the end of prior hiking cycles. That could limit returns going forward.
• Finally, inflation remains too high and Fed Chair Jay Powell characterized the labor market as “very tight.” That means it will be difficult for the Fed to pivot to rate cuts any time soon. In many of the historical examples above, the Fed started cutting rates not long after pausing rate hikes.

In our view, the outlook for equity markets hinges on whether the US economy can achieve a soft landing or if it slips into recession. While a soft landing is certainly a possibility, we believe stocks are already pricing in high odds of this outcome. In a soft landing, the S&P 500 could rise 5–10% to our upside year-end price target of 4,400. By contrast, if a recession unfolds, stocks could fall around 20% to our 3,300 downside target price. As a result, we find the risk-reward for stocks unappealing especially in the context of reasonable return potential in the fixed income market.

Main contributors: David Lefkowitz, Nadia Lovell, Matthew Tormey

Original report - What happens after the Fed pauses? , 17 May 2023.