Global Equity Strategy/CITI’S TAKE
Two years after delivering its first cut of the cycle, Citi economists believe the Fed will hike rates this week. Risks from more restrictive monetary policy (from the Fed and other key global central banks) compound preexisting worries around higher long-end bond yields. So, will higher yields derail the current equity bull market? On the Fed, we find that global equities tend to wobble around the start of hikes, while still climbing 6/12m later. On the long end, we find that underlying macro conditions remain key; equities can better digest higher bond yields when growth stays resilient, while falling inflation also helps. All this would suggest more short-term caution amid stagflationary risks from geopolitics. We nevertheless remain comfortable with our call for further earnings-driven upside for global equities to mid-27.
Rates Risks Growing — Citi economists see the Fed hiking this week. The shift towards tighter monetary policy extends past the US; more global central banks are now hiking than cutting for the first time in years. Citi economics expect a BoJ hike this week, recently added ECB hikes to their forecasts, and now pencil in BoE hikes as well. Meanwhile, long-end bond yields continue to rise globally, with 10Y US Treasury yields notably climbing above 5%.
Fed Hikes: Lessons From History — We examine equity performance around the start of Fed hiking cycles going back to the 1970s. We find that global equities tend to wobble around the start of Fed hiking cycles, while still rising on average 6-12m later. The US market tends to underperform after the first hike, while Japan and Europe typically outperform. Value tends to outperform Growth. In EM, Brazil and India tend to outperform, while China lags.
Higher Long-End Yields: Lessons From History — We examine prior US bond selloffs similar to today (+50bps over a 3m period). We find that sharp rises in 10Y yields are not universally bad for equities. Underlying macro conditions remain key; equities can better digest higher bond yields when growth stays resilient, while falling inflation also helps. Citi economists see manufacturing PMIs falling (but still >50), but geopolitics may skew inflation risks to the upside. This all paints a somewhat cautious picture and suggests de-escalation in the US-Iran conflict could remain key.
What About the Yield Curve? — According to Citi Rates Strategists, oil prices remain a key driver of the yield curve over the near-term. Higher oil prices would likely imply flatter curves, while lower oil would imply steeper curves. We highlight performance in various yield curve regimes, as well as correlations among global regions, European sectors, and EM countries to yield curve developments.
Implications & Views — It is not the first Fed hike that ends equity bull markets, although it does inject near-term volatility. Meanwhile, the impact of higher long-end yields is reliant on underlying macro drivers. This all emphasizes the importance of broader context. Given Citi’s house view that global growth is likely to stay resilient, we remain comfortable with our call for further earnings-driven upside for global equities to mid-27. However, we must acknowledge rising stagflationary risks (via geopolitics) and growing market exuberance, as evidenced by our Bear Market Checklist at post-GFC highs.
The Fed and the Long End
Almost two years ago exactly, the Fed delivered its first rate cut of the cycle. This week, Citi economists see US policy rates rising again. A sustained Fed hiking cycle remains unlikely, in their view, and the rate increase is likely to be presented as a “calibration”. But a shifting narrative on policy rates extends past the US. The ECB has already begun its hiking cycle, and Citi economists recently added two more hikes to their forecasts. The team also shifted their view on BoE and now expect two rate rises from here. And the BoJ is expected to deliver a total of four hikes—this week, then in January, June, and December next year. And broadly speaking, the number of central banks hiking rates over the past six months now exceeds those cutting (Figure 1). Risks from policy rate hikes compound preexisting worries around higher long-end bond yields. Even if hikes can ultimately help anchor the long end, global bond yields have risen meaningfully in past years, even against a global rate cutting cycle.
In this report, we lean on history to explore both sides of the rates story—the Fed and the long end—and their implications for equities. Ultimately, we find that global equities wobble around the start of Fed hikes, but initial tightening does not mark the end of bull markets. And on long-end rates, we find that the reason for higher rates remains key. Should global growth remain resilient, equities can remain similarly strong in a rising yield environment. Rate rises associated with stagflationary dynamics are more problematic. For now, this leaves us comfortable with our call for further earnings-driven upside for the MSCI AC World to mid-27, although stagflationary risks are clearly rising against signs of market exuberance.
Part I: Fed Hikes: What to Do
To understand the impact of Fed hikes, we first look at asset price performance at the start of previous Fed fund cycles. This includes macro assets (USD and bond yields), regional equity market differentiation, and style performance.
Macro: USD and UST
On average the dollar was relatively flat one year after the first Fed hike, albeit with a wide range of outcomes. DXY strengthened significantly in 2022, while 1977 and 1994 were characterized by dollar weakness.
There is a clearer pattern for bonds, with 10Y US Treasury yields rising 50-100bp one year after the first Fed hike. Yields notably fell in 1997 when the Fed delivered a single hike before going on hold and then cutting rates in 1998 around international market volatility (e.g., AFC)
Equities: Regions, Sectors, Syles
Global equities tend to rise into the start of Fed hikes (Figure 5). In only two cases (2015, 1994) did global equities fall in the 12m preceding hikes (Figure 5). On average, we find that global equities have risen 16% on average in the year preceding Fed tightening, and c4% in the 3m prior.
History is less consistent after the hike, with equities wobbling in the first 3m following a rate-rise (Figure 6). Three months after the first, equities have risen in only around one-third of cases. However, stocks have risen in the majority of cases 12m later, rising c7% on average.The US market tends to underperform after the first hike (Figure 7). While not always the case, DM ex-US (EAFE) has outperformed the US market by 5-10% on average one year after the start of Fed hikes. On a 6m horizon, median relative performance for Japan and Europe looks best, while the US and Australia lag (Figure 8). Hit rates for positive performance remain relatively similar across regions but are just north of 50% for both Japan and Europe.Value also tends to outperform 3m and 12m following the first Fed hike (Figure 9). While the 1999 experience (i.e., the build-up to the TMT bubble) is a clear outlier, Value sectors have typically outperformed Growth following the start of a hiking cycle. On average, global Cyclicals do better than Defensives after the Fed hikes.Global Energy, Consumer Staples, and Tech tend to outperform around the start of hikes, while Real Estate, Utilities, and Health Care lag (Figure 10). In Europe, Basic Resources and Banks also outperform, while Lux Goods and Telecoms lag on average (Figure 11). In EM, Brazil and India tend to outperform Poland and China (Figure 12).
Implications & Views: Equities and Fed Hikes
Ultimately, history suggests three key takeaways for investors:
1. It is not the first Fed hike that ends equity bull markets. While stocks tend to wobble around the first hike, it has typically paid to buy into any volatility with a one-year horizon. The same can’t be said for bonds, where it has generally paid to sell US Treasuries.
2.Regional rotation favors RoW. While global equities still tend to rise following the start of hikes, US underperformance has been a consistent trend, with Japan and Europe consistently outperforming.
3. Lean into Value (and more mildly in Cyclicality). This generally aligns with regional performance trends, suggesting intra-market rotation.
Of course, there is no “average” Fed hiking cycle, and much could be different this time around (indeed, Citi economists don’t view this hike as the beginning of a cycle)—but our findings leave us comfortable with our call for more global equity upside to mid-27. Indeed, history leads us to the conclusion that Fed tightening is a reason to expect near-term volatility, but hikes alone do not precipitate the end of bull markets. And should EPS growth remain solid—with both economic growth and AI sentiment remaining in-tact—there is reason to believe equities can rise even against US policy rates. History would also support the general path towards market “broadening” with an ex-US and Cyclical/Value tilt.
However, we must admit that our preferred gauge of market exuberance—the Bear Market Checklist— is now at its frothiest level since the GFC (Figure 13). This means the broader market context around rate hikes has already become more difficult to navigate. As we have previously noted, global capex growth has risen significantly, mostly attributable to AI hyperscalers. The announced/expected IPOs of several megacap US companies pushed the global IPO factor into amber category for now. Global EPS is getting stronger, and sentiment is picking up (via stronger flows, bullish stock analysts, and a “euphoric” Levkovich indicator). Only a few factors in our BMC, such as select leverage measures and credit spreads, remain at more benign levels.
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