Do Value Stocks do Better than Growth Stocks after the Fed Raises Rates?
The commonly held perception is that when the Federal Reserve is tightening, equity returns are lower than when the Fed is easing. It is also a commonly held perception that value stocks will do better than growth stocks when the Fed starts to tighten. This is because higher interest rates resulting from Fed tightening are thought to have less of an effect on value stocks with their relatively more stable and predictable cash flows than on growth stocks with more distant and less certain cash flows. The Fed has made known that it plans to raise rates, mostly likely starting in March 2022.
However, market participants should be aware that the relationship between U.S. monetary policy and equity returns is often not straightforward. The headline recognizes that Fed tightening is likely to result in lower stock prices, but that other factors — in this case expected earnings or growth of the economy — may offset the effects of the tighter policy. For example, between June 2004 and June 2006, the Fed raised the fed funds rate 13 times from 1.00% to 5.25% and the U.S. market went up 19%. The converse can also hold. The financial crisis which started in 2007 is an extreme example of the inverse relationship between Fed Reserve policy and equity returns. Between August 2007 and December 2008, the Federal Reserve cut the fed funds rate 8 times from 5.25% to .25%, yet the U.S. stock market fell over 37%.
This report explores how value stocks vs growth stocks have relatively fared 1 month, 6 months, and 12 months after the Fed raised fed funds rates. It looks at the relative returns when the Fed first starts to raise rates and midway through the fed funds rate hiking cycle. (One does not know the midway point at the time but only after the Fed stops hiking rates.) The analysis starts in 1982 since it does not make sense to go back further because the Fed started targeting interest rates only in 1982, and not in earnest until a couple of years later.
What happens after the start of each episode of hike of fed funds?
Figure 1 below shows the relative return of the Russell 1000 Value vs Russell 1000 Growth measured from the start of each episode of the Fed raising the fed fund rates. The Russell 1000 Value outperformed the Russell 1000 Growth in the last two episodes starting in December 2015 and June 2004. However, in the episodes before that when the Fed started to raise fed fund rates, the results were much more mixed. Value stocks do not always do better relative to growth stocks. One would have thought that as the Fed raised rates starting in June 1999 during the tech/dotcom bubble that value stocks would have outperformed immediately. This was not the case. Value stocks continued to underperform growth stocks 6 and 12 months after the initial rate hike.
What happens after the midpoint of each episode of hike of fed funds?
It may be hypothesized that it takes longer for Fed action to have an effect on the cost of capital and the relative performance of value vs growth stocks. Figure 2 below shows the relative return of the Russell 1000 Value vs Russell 1000 Growth measured from the midpoint of each episode of the Fed raising fed fund rates. Here the picture continues to be mixed. The Russell 1000 Value only outperformed the Russell 1000 Growth 2 times looking 6 months out and only 4 times looking 12 months out.
It appears that the relationship between U.S. monetary policy and equity returns is often not straightforward. Even though the financial press currently states growth will be underperforming value now that the Fed plans to raise the fed funds rate, the relationship has not shown a consistent pattern based on the historical data.