This can be used to deduce that a stagflation scenario in which central banks are forced to raise interest rates due to inflation, even in times of negative economic growth, would be the least favourable for the equity markets.
Including balance sheet reductions in the analysis
There is also the question of how an interest rate hike combined with a balance sheet reduction by central banks affects the markets. Such a situation occurred in the USA in the fourth quarter of 2018. At that time, the markets reacted negatively to interest rate hikes, even though there was no recession. Since the 2008 financial crisis and during the coronavirus crisis, the balance sheet of the Fed and other central banks has expanded considerably. Reducing these balance sheets, combined with potential interest rate hikes, is likely to be a challenge in terms of the stability of the financial markets.
«Healthy» interest rate hikes do not usually hurt
In conclusion, interest rate hikes are not necessarily bad for equities. If interest rates rise in times of intact economic growth, this can be considered a «healthy» rise. The economy and equity markets can cope with this without suffering damage. In this case, an interest rate hike can even be interpreted as a sign of strength.
Due to the «backlog» in monetary policy, the central banks do well to gain breathing room with healthy interest rate hikes and thus reduce the probability of one day standing with their backs against the wall. If this is successful, equities (and other risky assets) are a good investment, even in phases of interest rate hikes.
1 It concerns the return before inflation. Since interest rate hikes usually occur in periods of increased inflation, a loss of purchasing power may result in spite of positive returns. On average, inflation was 5.8% (YoY) in the period under review during interest rate hikes.