Against the backdrop of interest rate hikes, who is the only winner...?

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Rate hike

If a rate hike is unavoidable, which asset is most likely to outperform?

According to a report from Barclays strategist Venu Krishna's team, in the quarter when rate hikes began in the US in 1994, 1999, 2004, 2015, and 2022, the S&P 500 median fell by 3.9%, and the Russell 2000 median declined by 7.2%. Financial stocks performed the worst, with a median drop of 8.4%; energy stocks performed best, with a median increase of 0.3%, making them the only sector to achieve a positive return.

Barclays believes that rate hikes usually happen in the late stage of economic expansion, when the economy still shows resilience and demand hasn't noticeably weakened, but the stock market may begin pricing in a slowdown or even recession in advance. Thus, financial, healthcare, utilities, and consumer staples have larger declines, while industrials, materials, and consumer discretionary also pull back, whereas technology and communication services are relatively resilient.

This seems a bit strange: it's expected for financials to fall due to a flattening yield curve and increased credit risk from rate hikes. But why do healthcare, public health, and consumer staples also drop ahead? Aren’t these defensive sectors? Isn’t the point of defensive sectors to protect during an economic downturn?

Barclays believes this is because defensive sectors are typically high-stability, high-cash-flow, high-dividend assets. When the economy is strong, investors are unwilling to pay a premium for steady cash flows. When rates rise, high interest rates suppress the valuations of high-dividend and long-duration assets. Traditional defensive assets have value attributes like long-term bonds: stable and long-term, but lacking growth flexibility. So, they end up unappealing on both sides.

Finally, the energy sector stands out because early-stage rate hikes typically come in the late phase of economic expansion, when growth remains resilient and real demand hasn't noticeably weakened. That supports commodity prices. This explains why energy consistently outperforms the broader market over five rate hike cycles. Even stretching the observation period to the entire rate hike cycle, energy’s median annualized performance still ranks at the top among sectors.

Regarding style factors, during the first rate hike, large-cap leads small-cap, and value outperforms growth. Small-cap catches up after about two months. For thematic factors, momentum is stronger in the weeks before the rate hike, but becomes volatile afterwards. Statistics show that from the first rate hike to the last, the S&P posts a positive annualized return each cycle, with the median around 5.6%.

Jason believes Barclays says the S&P posts positive annualized returns each cycle from the first to the last rate hike, but that’s because Barclays doesn’t count the quarter before the hike. Often, it's more turbulent before the hike due to heightened sensitivity to market turning points and the transition from no hike to hike. When things are finally settled, the pressure isn’t that great.

Therefore, between inflation and rate hikes, whichever lands first—the uncertainty hanging over the market is weakened. This is why I think Walsh speaking hawkishly on Friday might trigger both stocks and bonds to rise together.