Worried about Fed rate hikes? Bell Potter says relax (these charts show why)

For many Australian investors, the path to building wealth increasingly runs through Wall Street.

Whether it's through an S&P 500 ETF, a technology fund or simply via superannuation, US shares now make up a significant portion of many portfolios.

That's why every hawkish comment from the US Federal Reserve attracts so much attention. With markets now pricing in further rate hikes over the next 12 months, has the bull market finally met its biggest threat?

Bell Potter strategist Rob Crookston doesn't think so.

"The reflex is to read hikes as a headwind for equities, with the 2022 cycle still front of mind. However, history says otherwise," he says.

In a new note titled 'Hikes Rarely Wake the Bears', Crookston argues that while higher interest rates may create bouts of volatility, history suggests they have rarely been enough on their own to derail a bull market.

History tells a different story

Conventional wisdom says higher interest rates should weigh on equities. Borrowing costs rise, company valuations come under pressure and bonds become more attractive relative to shares.

But Crookston argues investors are missing an important point: the Fed typically raises rates because the economy is strong, not because it's weak.

Looking at every Fed hiking cycle since the early 1970s, Bell Potter found US equities have generally continued to produce positive returns even as monetary policy tightened.

"A Fed hiking cycle on average is not a headwind for the market."

Since 1971, the S&P 500 has returned around 9% on average in the 12 months following a Fed rate hike. Across the past 10 hiking cycles, the index has delivered average gains of 6.5%, while the technology-heavy Nasdaq has averaged 7.1%, as shown in the chart below.

The Fed tends to tighten policy when economic growth is healthy, corporate earnings remain resilient and unemployment is low. By contrast, it usually cuts rates when recession risks are rising.

"Therefore, earnings typically remain strong and outweigh the negative impacts of hikes," Crookston says.

"A fast-cutting cycle, which tends to cluster around recessions, is the one associated with weak returns. The reflexive instinct to sell equities into a hiking Fed runs counter to history."

Why this isn't another 2022

Understandably, many investors still carry the scars of 2022, when the Fed's most aggressive tightening campaign in decades triggered a painful sell-off across both equities and bonds.

Crookston acknowledges the comparison but says today's backdrop is fundamentally different.

"The 2022 cycle, where inflation peaked near 9% and the Fed was visibly behind the curve, produced a max drawdown of roughly 20% during the cycle."

He points to three key differences.

First, inflation is nowhere near the levels seen four years ago. Inflation expectations remain well anchored, reducing the risk that policymakers need to aggressively chase rising prices.

Second, interest rates are already sitting well above emergency settings. Unlike 2022, when the Fed was forced to lift rates by more than five percentage points from near zero, any additional tightening today would likely be a modest, pre-emptive move rather than a catch-up exercise.

Finally, while US equities aren't cheap, valuations remain below the extremes reached during the zero-interest-rate era (see below).

Taken together, Crookston believes today's environment looks much closer to previous "equity-friendly" hiking cycles than the extraordinary inflation shock investors experienced in 2022.

"A 2026 hike, if it comes, would be a pre-emptive move against a strong US economy with inflation expectations anchored. That is far closer to 1994 or 2004-06 than to 2022," he says.

Expect volatility - but watch AI instead

None of this means investors should expect a smooth ride.

Every Fed hiking cycle since the early 1970s has included meaningful market pullbacks. The median drawdown for the S&P 500 has been around 10%, while the Nasdaq has typically experienced declines closer to 20% during tightening cycles (see below)

The difference is that those corrections haven't usually marked the end of the bull market. In nine of the past 10 hiking cycles, the S&P 500 ultimately finished higher despite experiencing significant volatility along the way.

Instead, Crookston believes investors should pay closer attention to a different risk: whether the AI investment boom ultimately follows the path of previous manias.

"Every capex-led tech boom, from railways to telecom and dotcom, ran the same course: heavy investment, capacity built ahead of demand, returns falling below the cost of capital, then write-downs and a sharp correction," he says.

"The risk for markets is that the Fed supplies the same catalyst for the end of the dot-com bubble: a rising cost of capital that curtails the capex spend."

For now, Bell Potter doesn't believe those conditions exist. Credit spreads remain tight, long-term bond yields have eased and today's AI investment boom is being funded largely by the cash-rich balance sheets of mega-cap technology companies rather than speculative debt.

"This build looks to be better insulated than its predecessors, funded largely from strong mega cap tech balance sheets, whereas 1990s fibre build out was speculative and debt led," Crookston says.

"However, this could be a source of concern for the market and worth monitoring. Further Fed hikes getting priced in could induce more volatility."

As far as positioning goes, Bell Potter remains overweight US equities and emerging markets, citing stronger earnings growth and more attractive valuations. The broker remains underweight Australian equities, arguing domestic earnings momentum continues to lag offshore.

Funds

Keep calm and keep buying quality tech, says Bell Potter

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