The end of the Federal Reserve's interest rate hike cycle does not necessarily mean a weakening of the US stock market! However...

Why has the NASDAQ Composite Index outperformed this year?

Since the beginning of the year, the performance of the US stock market has exceeded expectations. It is widely believed that under the background of interest rate hikes, there is increased valuation pressure on US stocks. However, from the beginning of the year to the present, the NASDAQ Composite Index has risen by 34.8%, while the S&P 500 and the Dow Jones Industrial Average have risen by 17.3% and 4.1% respectively.

According to West Securities:

Historically, the end of an interest rate hike cycle does not necessarily mean a weakening of the US stock market.

Looking at the past four interest rate hike cycles, from October 1994 to July 1995, all three major US stock indexes achieved positive returns, and the NASDAQ Composite Index showed significant strength. From January 2006 to November 2006, US stocks also achieved positive returns. This may indicate that on the one hand, the suppression of US stock valuations by interest rate hikes weakens after the interest rate hike cycle, and on the other hand, it still depends on the impact of economic events at that time.

In 2000, the significant decline of the NASDAQ Composite Index was mainly due to the impact of antitrust cases on the profitability of technology companies and the increase in international oil prices, which intensified market expectations of interest rate hikes by the Federal Reserve. In the second half of 2018, the fading of the Trump tax cuts, weakening actual GDP growth, and declining corporate profits in the US stock market, coupled with weak expectations of interest rate cuts, constrained the rise of US stocks.

Growth has outperformed value, partly because the NASDAQ experienced a significant decline last year, and valuations have fallen back to a "reasonable range" this year. Additionally, it has been driven by hot sectors.

From a data perspective, not only has the NASDAQ Composite Index far outperformed the Dow Jones, but also in terms of the performance of industries within the S&P 500, the information technology and communication equipment sectors have risen by nearly 44% and 40% respectively, far exceeding other sectors.

The return of the price-to-earnings ratio to a reasonable range is one of the reasons. The NASDAQ PE ratio rose rapidly under quantitative easing in 2020, and then fluctuated downward in 2021-2022, until 2023, when its valuation returned to pre-pandemic levels.

In addition, the AI boom triggered by ChatGPT and other large language models has prompted investors to flock to large-cap technology stocks, many of which are included in the NASDAQ and are related to AI. The hot sectors in the industry have been the main contributing factors to the current rise in US stocks.

Furthermore, this year, the "downward" trend in US inflation and the "strong" job market have intensified expectations of an economic soft landing.

In June, US CPI rose by 3% compared to the same period last year, lower than expected and the previous value. This is mainly due to the decline in energy prices and the high base effect from last year, and overall inflation has fallen in line with expectations this year.In contrast, the resilience of the labor market has shown unexpected performance, not only with a strong increase in total employment, but also with the unemployment rate remaining at a historically low level. The Federal Reserve has continuously revised its unemployment rate forecast for 2023.

Although the banking crisis and debt ceiling have caused disturbances in the U.S. stock market, the expectation of a soft landing for the U.S. economy has been strengthening due to problem resolution, consumer spending, and support from the labor market. This has boosted risk appetite and corporate profitability.

The probability of a soft landing for the U.S. economy has increased, and the U.S. stock market may maintain a volatile upward trend, but risks should not be underestimated.

Currently, the U.S. inflation is lower than expected, the service industry and labor market show strong resilience, and there are signs of stabilization in the real estate sales sector. This is favorable for achieving a soft landing for the U.S. economy and maintaining a pattern of volatile upward movement in the U.S. stock market.

However, it is expected that the fastest time for inflation to decline has passed, and downward pressure on the fundamentals still exists. Risks should not be underestimated:

Firstly, valuation pressure comes from the upward adjustment of terminal interest rates. Whether the adjustment exceeds market expectations will determine the temporary pressure on the U.S. stock market.

Currently, there is still a divergence between the Federal Reserve and the market. The market mainly believes that after the rate hike in July, the Federal Reserve will end the rate hike cycle and start a rate cut cycle in March 2024. However, Powell has proposed "Higher for Longer" and the dot plot shows that there is still room for a 50 basis point rate hike in the future. This may mean that bridging the gap between the two opinions will cause certain disturbances in the U.S. stock market.

In addition, neither party has priced in the risk of a second rise in inflation. If inflation turns upward in the future, the path of rate hikes will change from "quantity" to "quality".

Secondly, geopolitical uncertainties may also lead to a re-balancing of asset prices.

Thirdly, although recent U.S. economic data has exceeded expectations, economic recovery and declining inflation cannot be achieved simultaneously.