The current bull market is over six years old and has survived several calls for its demise. So far, it has weathered economic weakness, deflation fears, earnings slowdowns, an oil collapse, the surging dollar, geopolitical risks and valuation worries. The latest bugaboo is one that has often been associated with corrections or the onset of bear markets: the start of a Federal Reserve rate hike cycle and rising bond yields.
 
We believe such concerns are likely overwrought. We expect rates and yields to rise in the coming months. But while this will likely contribute to market volatility, it shouldn’t spell the end of the current bull market.
 
 
A Look at History: Fed Rate Cycles and Equity Markets
 
Many investors believe that when rates rise, the party is over for stock prices. Historically, however, this has not been the case.
 
Consider the past six rate hike cycles going back to the early 1980s. Using time periods of 250 trading days (roughly equivalent to one year), we found that while pockets of weakness surrounded rate hikes, equities generally weathered the storm. In most cases, equities performed well prior to Fed rate increases, then struggled or declined slightly after the onset of rate hikes, only to recover and outperform in the two years following the first rate increase.

Equities Survived Previous Fed Rate Hikes


S&P 500® Index Returns Before and After Rate Increases

Performance Before/After Initial Rate Hike
Date of Initial Hike 250 Days Before 250 Days After 500 Days After
5/2/198336.60%-1.10%12.20%
12/16/198619.10%-5.90%11.20%
3/29/1988-11.40%11.70%30.60%
2/4/19945.30%0.60%34.10%
6/30/199919.70%6.00%-10.70%
6/30/200414.80%4.40%9.10%
Average 14.00% 2.60% 14.40%

While equities have generally performed well before and after Fed rate hikes, we have seen increased volatility. In particular, a period of consolidation often accompanied the start of rate increases. The table shows the average daily returns of the six time periods discussed above. In the 250 days before the rate increases and the 500 days after, stock prices trended higher but experienced a modest selloff. The numbers are different for each of the six time periods, but on average, equities have experienced a peak-to-trough decline of roughly 10%.
 
 
Improving Growth and Signs of Inflation Should Push Rates Higher

In some ways, the current economic and market backdrop is typical compared to previous periods of rising rates. In a normal economic cycle, the economy emerges from recession as the Fed cuts rates and tends to grow relatively quickly during a time of low inflation. At some point, the backdrop shifts and the Fed begins increasing rates, usually due to climbing inflation or improving growth. This Fed policy shift divides the first and second halves of economic expansions.
 
Today, we believe the United States has reached that inflection point: Economic growth has been slower than typical recoveries and expansions, but it is gradually accelerating. Despite a few blips, growth could be characterized as solid, and indicators such as the strengthening labor market suggest this growth will continue.
 
Inflation is more complicated. For years, inflation has been virtually nonexistent in the United States, but we believe that is changing. The sharp and dramatic collapse in oil prices since mid-2014 has put downward pressure on headline and core inflation. We are, however, seeing indications that some inflationary pressures are starting to emerge. We believe overall inflation is bottoming and will begin moving modestly higher.
 
Wage inflation is one critical signal for inflation. If and when wages start to climb, consumer spending should increase, which may increase demand for goods and services and start an inflation cycle.
 
Wages can be measured in several ways, but we believe the best measure is the quarterly Employment Cost Index (ECI). Since the end of the Great Recession, the ECI jumped early and leveled off for several years. That has recently begun changing. The first quarter of 2015 reading showed the ECI climbing at its fastest annual pace in six years.
 
As a result of improving growth and inflation pressures, we expect the Fed will begin increasing rates, and bonds yields should move erratically higher. The United States is hardly in a robust growth mode, and inflationary pressures are only beginning. Unlike previous cycles, the Fed is under no pressure to rein in unsustainable growth or curb mounting inflation. The important issue, however, is that the U.S. economy is strong enough to withstand higher rates.
 
The unprecedented lowering of the fed funds rate to zero happened as a result of an emergency—the worst financial crisis since the Great Depression. That emergency is long past, and we believe it is time (if not past time) for the Fed to act. Our best guess is that the Fed will begin to increase rates in September 2015. When the Fed moves, we believe it will do so slowly and carefully. At the same time, we think bond yields should rise unevenly. Both the start of the Fed rate cycle and improving growth trends should put upward pressure on yields.

The Starting Point Should Help Equities

There is a key difference between the current environment and previous rate increase cycles—the starting point is much lower. For the first time in history, the Fed will be raising rates from such a low level and bond yields are much lower than other rate increase cycles.
 
We see a couple of implications of this unique environment. The fed funds rate has room to move higher before it drags on economic growth. For example, if the Fed enacts four or five 25 basis point rate increases over the coming year (a reasonable expectation), the fed funds rate would increase to just 1.0% to 1.25%. This would hardly be punitive by any measure. During the previous six rate hike cycles, the fed funds rate started at an average of about 5%. Put another way, the current economy is probably still weak enough to need low rates—just not quite so low.
 
A second, and related, implication is that an environment of low and upward moving rates can be a good backdrop for equities. Not surprisingly, equities fared poorly when yields were high and moving higher. while they performed well when yields were decreasing from elevated levels. Interestingly, stock prices also tended to rise significantly when yields were low and starting to move higher.
 
Presently, the 10-year Treasury yield is around 2.25%. In the previous six time periods we discussed earlier, Treasury yields were much higher when rates started to rise. During those times, the 10-year yield ranged from 4.6% to as high as 10.3%, with an average starting point of 7.0%. This supports our argument that rising rates and yields won’t be enough to derail the current bull market.

Investment Implications: Performance Trends and Active Management

We see several implications for investors. The first is that equities will continue to outperform most other asset classes in the coming months and years. Equity valuations are higher now than a few years ago, but remain more attractive than cash and many areas of the bond market. A combination of improving growth, solid earnings and favorable valuations suggests that investors may want to overweight equities.
 
A look back at the historical time periods we have been considering suggests the same. Comparing different segments of equity markets with other asset classes,
 
We would caution not to make too much of these numbers, as they compare different asset classes over various time periods and diverse market environments. However, a few trends may repeat this time:
Equity markets generally outperformed Treasuries and corporate bonds.
 
Large cap equities outperformed small caps. Larger companies tend to have more stable earnings trends, and earnings become increasingly important in the second half of economic cycles.
 
Global equities outperformed U.S. equities. U.S. stock prices usually become more volatile and experience a downturn sometime during rate increase cycles. Since many regions of the world are still in a monetary policy easing mode, we expect some near-term outperformance by non-U.S. markets. However, we continue our favorable long-term view toward U.S. equities.
 
In addition to these broad asset class views, we also have some thoughts about specific sectors of the U.S. equity market. Sector returns tend to be volatile over time, but the 12-month average returns of the S&P 500 sectors following the last six rate hike cycles show consistent trends.
 
During periods of rising rates, valuations for equities tend not to expand, so earnings growth becomes the main driver of equity returns. Not surprisingly, sectors that tend to exhibit better growth prospects have generally outperformed during periods of rising rates. This gives us a positive view toward the technology and health care sectors, which we believe look quite attractive.
 
We believe a few historic trends will not reoccur in this cycle. Energy has historically performed well, but the recent collapse in oil prices combined with slowing growth in China will keep downward pressure on the energy sector for some time. Likewise, the utilities sector appears vulnerable, as valuations for this area appear stretched. We do not expect this part of the market to outperform.
 
Finally, we examine a historical connection between rising rates and active equity management. Over time, active managers have struggled when yields have fallen. Conversely, active managers have outperformed when yields are rising.
 
This connection exists for several reasons:
 
Rising interest rates tend to be associated with periods of market volatility. We believe more volatility means more opportunity for active managers to identify mispriced securities.
 
Rising rates typically signal accelerating economic growth. Stronger economic growth leads to more market breadth, and hence more performance dispersion. This can benefit active approaches.
 

Expect More Volatility, but Equities Should Still Advance

We understand why many investors view the prospect of higher rates with trepidation. The Fed’s highly accommodative monetary policy has been a main contributor to the extremely strong bull market we have enjoyed over the last several years. This policy shift will diminish what has been a strong tailwind.
 
Nevertheless, we believe equities have room to rise. The coming change in Fed policy is likely to bring additional volatility, and we believe the pace of equity gains will likely recede. But the balance of evidence suggests that stock prices are more likely than not to advance over the coming months and years.
 

Doll is chief equity strategist with Nuveen Asset Management, an affiliate of Nuveen Investments.