In the few months since March 16, when the Federal Reserve (Fed) finally started hiking policy rates in response to spectacularly high inflation, U.S. equities have tumbled. Since Fed liftoff, the S&P 500 has fallen 13%, bringing the total decline since the market’s peak in early January to over 21%—almost erasing all last year’s gains.

Such a negative immediate market response to Fed tightening is unusual. During the previous six Fed hiking cycles (dating back to the late 1980s)1, the S&P 500 had, on average, delivered a 15.6% positive return during the initial 12 months after the first hike. For investors, the first step in deciding whether the most recent equity drawdown is complete is to unravel why the equity market response has been so much worse than previous Fed tightening cycles.

Equity markets 101

Equity market performance is largely driven by two key factors, valuations and earnings. Consider, in the first 12 months of the previous six hiking cycles:

Valuations have typically contracted. A rising interest rate environment is generally negative for equity valuations as investors need to discount future cash flows with higher yields.

Earnings have typically risen. As the Fed often tightens monetary policy into a strengthening economy, earnings growth usually remains solid in the first 12 months after the hiking cycle starts, only slowing once higher rates have eventually fed through to the real economy.

On average, stronger earnings have more than offset the valuation contraction, driving a positive equity market performance. Indeed, breaking down the average S&P 500 price returns for the previous six hiking cycles reveals that earnings grew 22% on average, significantly outweighing the -4% loss stemming from valuation compression, resulting in a positive 15.6% return.

In the current cycle, valuation compression has been more significant than average, proving to be a powerful headwind to equities and, although not negative, earnings growth has been meaningfully weaker, providing insufficient support to equity markets.

S&P 500 performance over the previous six hiking cycles
Total return, 0 = month of rate action

Line graph showing S&P 500 performance over the previous six hiking cycles

Bloomberg, Principal Global Investors. Data as of June 30, 2022.

It’s (sort of) different this time

Valuation compression

The key factor driving equities lower this year has been the hawkish Federal Reserve and the resulting steep rate expectations which, in turn, have significantly pressured valuations. In the space of three months, the S&P 500 P/E ratio has dropped from 22.8x in March to 19x today, a 17% valuation compression and a spectacular move even by historic comparisons.

The Federal Reserve has only recently recognized the full extent of its previous erroneous read of the inflation situation and has now committed to bring down inflation through aggressive tightening, seemingly irrespective of how the U.S. economy responds. With the Fed playing a risky game of catch-up, the current trajectory for policy rates (implied by futures) is significantly steeper than the average hiking path in the previous six cycles. To put into context, by the end of July 2022, in the space of just four months, the Fed’s tightening will likely have matched the Fed’s entire three-year hiking cycle of 2015–2018.

12-month change from first rate hike
Previous six and current Fed hike cycles

Bar chart showing 12-month change from first rate hike featuring the previous six and current Fed hike cycles

Bloomberg, Principal Global Investors. Data as of June 30, 2022.

In the current cycle, the market is anticipating Fed rate hikes to be front-loaded (larger increases at the start of the cycle), with policy rates ultimately rising 330 bps in the first year following liftoff.

The closest resemblances to this anticipated path are the hiking cycles in 1988–1989 and 1994–1995.

  1. In 1988–1989, although the Fed also raised policy rates by 300 bps in the first 12 months, the tightening was more back-loaded—gradual at the start, before accelerating towards the end of the first year. Valuations in the 12 months after liftoff contracted 17%—the same amount as has already been recorded in the current cycle.
  2. In 1994–1995, the Fed started tightening at a similarly rapid pace as today, but it ultimately “only” raised policy rates by 275 bps. Valuations compressed 27% in the first 12 months after liftoff.

Federal Reserve rate hike movement over the previous six hiking cycles
Total return, 0 = month of rate action

Line graph showing Federal Reserve rate hike movement over the previous six hiking cycles

Bloomberg, Principal Global Investors. Data as of July 13, 2022.

Earnings growth

Whereas valuation compression weighing on equity returns was sizeable in the 1988–1989 and 1994–1995 cycles, earnings growth was more significant, ultimately carrying equity returns into positive territory. In contrast, earnings growth in the current cycle has been considerably more muted, failing to offset the drop in valuations and resulting in the very poor performance of U.S. equities.

While earnings strength in a Fed hiking cycle may seem counter-intuitive, the current tightening cycle is the unusual one. The Fed has typically responded to higher inflation pressures as they emerge and, usually, inflation pressures have been driven by an over-heating economy. In those situations, earnings would have been strong as the Fed embarked on pulling back monetary accommodation. By contrast, in this cycle, the Fed waited until inflation had become entrenched and sticky before they responded, by which time price pressures were already starting to constrain household budgets, wage growth began pressuring corporate margins, and the economic slowdown had already kicked off.

The Fed’s delayed tightening response this year has meant that not only have market rate expectations soared, crushing equity valuations, but earnings growth was already slowing and therefore has been too soft to support equities higher.

From here, although U.S. valuations have contracted significantly, given stubbornly high inflation and Fed commentary emphasizing that price stability is their priority, valuations could still fall slightly further. Certainly, on a historical basis, as U.S. equities have still been cheaper around 80% of the time, there is little pressure for multiple expansion.

Yet, with the bulk of valuation compression likely now behind markets, whether they can bounce back or drop further will largely depend on if earnings momentum can recover and deliver strong growth. Early indications are not encouraging.

2022 expected earnings growth
August 2020–present

Line graph showing expected earnings growth in 2022 by looking back to Aug 2020

Bloomberg, Principal Global Investors. Data as of June 30, 2022.

Earnings watch—a bear is still lurking

At an aggregate level, while expected 2022 earnings growth has declined since early 2021, more recently, it has stabilized at around 10%. If this stabilization can be sustained in coming months, earnings growth could prove solid this year, and offer a decent buffer to additional U.S. equity weakness, despite ongoing valuation headwinds.

A look under the earnings hood, however, reveals some worrisome signs. While overall earnings growth has been stable, it’s been carried by the strength in deep cyclical sectors. Roaring commodities prices, for example, have sent energy and materials sectors earnings growth to the sky. On the other hand, many of the other S&P 500 sectors’ earnings are already moving in a downward trend, driven by margin concerns as inflation pressures mount and consumers pull back. If this negative momentum is maintained, and despite cyclicals best efforts, it risks bringing down the overall earnings outlook and dealing a significant blow to the equity market outlook.

Navigating in unchartered waters

Investors widely use historic trends and relationships to light the path ahead for markets. However, this recency bias may have already cost investors painfully. Analysis shows that the Fed is hiking at a more aggressive pace and into an already slowing economic environment—this time is (a bit) different.

The path forward will be largely earnings-led. Technical factors, such as investor sentiment, flows and cash allocations, as well as news of the much-awaited U.S. inflation peak, may set the stage for a short-term market rally. But until the effect of slowing, and even contracting, economic growth on earnings has been fully felt, and valuations fully capture the negative fundamental outlook, equity market headwinds will persist.

1 Hiking cycle in this paper is defined as period from the first hike to the month before the next cut. Before 1988, except for two episodes, hiking cycles tend to be short lived and difficult to use as reference. So, the analytical period in this paper is from 1988 to 2022. The six hiking cycles are Mar-’88 to May-’89, Feb-’94 to Jun-’95, Mar-’97 to Aug-’98, Jun-’99 to Dec-’00, Jun-’04 to Aug-’07 and Dec-’16 to Jun-’19. The last one technically started from Dec-’15, but Fed paused over a year before resuming consecutive hikes, so Dec-’16 was a more proper starting point for this analysis.


Risk considerations

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Investments in natural resource industries can be affected by disease, embargoes, international/political/economic developments, variations in the commodities markets/weather and other factors. Investing in derivatives entails specific risks regarding liquidity, leverage and credit that may reduce returns and/or increase volatility.

Important Information

This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.

This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

This material is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

This material is intended for use in:

  • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
  • Europe by Principal Global Investors (EU) Limited, Sobo Works, Windmill Lane, Dublin D02 K156, Ireland. Principal Global Investors (EU) Limited is regulated by the Central Bank of Ireland. In Europe, this document is directed exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by the MiFID). The contents of the document have been approved by the relevant entity. Clients that do not directly contract with Principal Global Investors (Europe) Limited (“PGIE”) or Principal Global Investors (EU) Limited (“PGI EU”) will not benefit from the protections offered by the rules and regulations of the Financial Conduct Authority or the Central Bank of Ireland, including those enacted under MiFID II. Further, where clients do contract with PGIE or PGI EU, PGIE or PGI EU may delegate management authority to affiliates that are not authorized and regulated within Europe and in any such case, the client may not benefit from all protections offered by the rules and regulations of the Financial Conduct Authority, or the Central Bank of Ireland.
  • United Kingdom by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London, EC2V7 JB, registered in England, No. 03819986, which is authorized and regulated by the Financial Conduct Authority ("FCA").
  • United Arab Emirates by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization.
  • Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act 2001. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.
  • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS License No. 225385), which is regulated by the Australian Securities and Investments Commission. This document is intended for sophisticated institutional investors only.
  • This document is marketing material and is issued in Switzerland by Principal Global Investors (Switzerland) GmbH.
  • Hong Kong SAR (China) by Principal Global Investors (Hong Kong) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance.
  • Other APAC Countries, this material is issued for institutional investors only (or professional/sophisticated/qualified investors, as such term may apply in local jurisdictions) and is delivered on an individual basis to the recipient and should not be passed on, used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
  • Nothing in this document is, and shall not be considered as, an offer of financial products or services in Brazil. This presentation has been prepared for informational purposes only and is intended only for the designated recipients hereof. Principal Global Investors is not a Brazilian financial institution and is not licensed to and does not operate as a financial institution in Brazil.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.

© 2022 Principal Financial Services, Inc. Principal® , Principal Financial Group® , and Principal and the logomark design are registered trademarks of Principal Financial Services, Inc., a Principal Financial Group company, in the United States and are trademarks and services marks of Principal Financial Services, Inc., in various countries around the world. Principal Global Investors leads global asset management at Principal® .

MM12999 | 2287154

About the author