A driver for much of last week’s positive performance in stocks was the FOMC minutes from their October meeting, indicating that a December rate-tightening start date is still very much alive. It also implies that the U.S. economy can handle slow, but gradual, rate increases.
Randall Forsythe of Barron’s magazine took their comment one step further, concluding that the Fed is planning to embrace a zero real-rate policy, or keeping the effective Fed funds rate close to the rate of inflation. Historically, the effective Fed funds rate has traded at an average premium of 1.95 percentage points above the rate of inflation (core PCE) since 1960, which would have pegged the ultimate short-term rate target at slightly above 3%.
A zero real-rate target would therefore keep rates below this historical norm. We all know that Wall Street loves low interest rates, but does history agree that keeping real rates (nominal rates minus core PCE) near zero would be positive for equities?
Sorting 12-month changes in the Fed’s favorite measure of inflation – the Core PCE – into quintiles since 1960, during periods when the Fed was in a rate-tightening mode, we see in the accompanying table that during the lowest quintile of real rates (-1.0% to +1.3%), the S&P 500 recorded a sub-par median forward 12-month price increase of 6.8%, versus the median of 8.4% for all rolling 12-month periods.
Yet the S&P 500 gained in price 94% of the time in the following year, compared with 72% of the time for all periods. What’s interesting is that as the real-rate quintile range increased, so too did the median forward 12-month price change for the S&P 500 up until the top quintile(+4.0% and Up), in which it fell sharply. Yet the reverse was true for batting averages. As median price increases rose through each and every quintile, the market’s batting average fell.
Today, the real interest rate is around -1.2%. Therefore, history suggests (but does not guarantee) that while investors should have an increased level confidence that the S&P 500 will rise in price in the coming 12 months, it also reminds us that we should not to get too greedy, as the “500” will likely rise at a below-average pace. Sometimes, slow and safe is preferred.