by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments
f last week's discussion was about whether another rate hike should worry investors, the next question is whether it should change make them consider changing what they own. The argument for making a defensive shift is easy to understand. Tighter policy is often associated with slower growth, slower growth is often associated with traditionally defensive sectors such as Utilities, Consumer Staples, or Health Care, and the conclusion can seem obvious. The challenge is that there has never been a single playbook for Fed hiking cycles because every cycle is different. For anyone who grew up settling childhood disputes with rock-paper-scissors, markets work much the same way. There is no always-winning move. Policy is only one hand being played alongside earnings, valuations, and sentiment. Those forces take turns driving market leadership, which is why investing rarely comes with a simple playbook.
That said, we can use the framework we've been building over the last several weeks to ask a more specific question: when nominal interest rates begin below nominal growth and the Fed responds with modest hikes, does leadership tend to favor offense or defense? The historical answer is surprisingly clear: offense. Technology has historically been the strongest performer in these environments, outperforming the broader market nearly 80% of the time. That result is consistent with a theme we've highlighted throughout this series: rate hikes often occur alongside improving growth expectations, and improving growth has historically mattered more than modest changes in policy (call it rock beating scissors). More broadly, while no sector wins every time and many economically sensitive sectors have odds that are closer to a coin flip, the dividing line between offense and defense remains remarkably clear. Traditional defensive sectors such as Utilities, Consumer Staples, Health Care and the former Telecommunication Services sector have underperformed the broader market by roughly five percentage points on average over the following year, while offensive sectors have tended to outperform. The message is not that rate hikes are bullish for every cyclical sector, nor that defensive sectors can never work. Rather, it's that modest tightening cycles have historically been a poor reason on their own to abandon offense and hide in traditionally defensive areas of the market.
One explanation should sound familiar by now: the Fed often follows the economic cycle rather than creates it. But there is another lesson we've encountered repeatedly as well: markets spend a great deal of time discounting risks before they ever occur. Bearish sentiment from retail investors, as measured by the AAII survey, surged again following the latest rate hike, pushing expectations back toward recession territory despite an economy that has yet to deliver one.
Historically, that matters: the more bearish investors already are, the less likely Utilities, arguably the market's most classically defensive sector, have been to outperform. If everyone is already preparing for the bad outcome, much of that fear may already be reflected in prices. Put differently, rate hikes alone have rarely been a compelling reason to get defensive, especially when investors are already worried that the next shock is just around the corner. Markets, of course, never tell us whether to throw rock, paper, or scissors before the game starts.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
Copyright © Fidelity Investments
