XSW - Jefferies Research: Previous long high-rate environments suggest current U.S. economy might be brighter than thought

2023-09-25 12:15:58 ET

Contrary to consensus, Jefferies strategists believe that the current high interest rates will not have adverse effects on the S&P 500 ( NYSEARCA: SPY ).

Although investors need to prepare for 75–100 basis point rate cuts in the market for 2024 not materializing, Jefferies’ chief market strategist David Zervos believes that a longer, tighter environment will coincide with a brighter U.S. economic outlook.

According to Jefferies Equity Research, the impact of rates in the 5–6% range for most of next year has a lot to do with four periods between 1995 and 1998, and 2006 and 2007, when the Fed rates stayed around those ranges.

“Contrary to the common concern that higher rates are going to have an adverse effect on equities, S&P 500 delivered an average return of c.25% (c.1.9% per month) through the cycle, led by infotech ( SMH ), healthcare ( XLV ) & telecom ( XTL ), while commodities & discretionary ( XLY ) lagged,” the research, published on Monday, read.

The S&P 500 delivered a return of at least 25% during each of the stable rate cycles between 1995 and 1998. During the 2006–2007 cycle, however, equities continued to perform well until the 10th month with a return of 20% before dropping to 16% in the last two months of the cycle.

Software ( XSW ), tech hardware, and pharma ( XPH ) outperformed the most during the previous stable 5–6% Fed fun rate periods.

Other similarities between the current cycle and the one at the start of 1995 to consider:

1. Rates prior to the 1994 hikes were at a 30-year low.
2. The 1995 pace of rate rises was “somewhat similar” to what we had in 2022, with the Fed doubling the rate (from 3% to 6%) in seven rate hikes, including the use of 50 basis points and 75 basis points moves.
3. Both rate rises did not lead to a recession, and the Fed achieved a soft landing, followed by a small rate cut in the 1995–1996 cycle and then a small hike in 1997, “technically creating three periods of stable rates around 5–6% that lasted until 1998.”
4. The S&P 500 growth index outperformed the value index. Growth performance was stronger during the 1995–1998 cycles but a lot slimmer during the 2006–2007 cycle.
5. Equities were on average up by more than 25% during the 1995–1998 cycles, and by more than 15% during the 2006–2007 cycle.

The current S&P 500 is up 13.9% this year since the end of June, when the rates were last raised, but the market is only up 4%.

Also, in the current cycle since June, energy ( XLE ) has performed the best, and defensives such as telecommunications ( XTL ), staples ( XLP ) and utilities ( XLU ) are underperforming the most. Since June, EV, energy ( XLE ), and insurance ( KIE ) performed the best, and telecommunications ( XTL ), durables, utilities ( XLU ) and FBT have lagged the most, the research showed.

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