If the Fed hikes rates, here's how the stock market might respond

Tuesday was another losing day for the S&P 500 — the sixth in the past seven. And it was pretty harsh, with equities driven down by concerns about artificial intelligence and surging oil prices.

The slide fits well with strong expectations that the Federal Reserve will hike its benchmark interest rate by 25 basis points when it wraps up its two-day meeting Wednesday.

Big corporations don’t like higher interest rates because they raise borrowing costs and put pressure on the consumers buying their products. But experts are mixed on how a potential cut will immediately affect the stock market.

“We probably shouldn’t expect a large and immediate impact of a rate hike on stocks, since it’s already priced in,” said Bill Merz at U.S. Bank Asset Management.

He said capital markets have been anticipating higher rates for a while, and once the Fed starts, it’s not usually one-and-done.

“There’s a limit to what a single rate hike can do. Markets are already pricing in three to four rate hikes by next summer,” Merz said.

It’s an open question how much rate hikes might drag on business investment and consumer spending, which are key drivers of corporate profits and stock prices. But up until now, they’ve held up well.

“S&P 500 earnings — they’re expected to grow about 31% this year and about 14% next year,” Merz said.

Jan Groen, chief economist at Societe General, had a less sanguine view of what’s coming: “I mean, [a hike is] definitely not priced into stocks,” he said. “So we’ll see what’s going to happen tomorrow.”

New Fed Chair Kevin Warsh hasn’t established his credibility yet, Groen said. And so far, Warsh has shunned forward guidance about interest rates.

“The market is just not really believing the Fed, that they really will have the willingness to go all the way,” Groen said.

Investors will eventually get the message, he said, with stock prices taking a hit later this year. He also predicted inflation will remain high, inducing the Fed to hike rates again.

Equity analyst Jeffrey Roach at LPL Financial has looked at the last 30 years of Fed rate-hiking. What he’s found mirrors something former Fed Chair Chair William McChesney Martin once said about taking away the punch bowl.

The punch in the bowl is low interest rates — the lubricating beverage that brings investors to the stock-buying party. When rates go up, Roach said, “you get the punchbowl taken away, you complain for a little bit, then after a while you just move on.”

Historically, stocks tend to fall for a few months, Roach said. But 12 months after that they’re back in the black, as companies and consumers adjust to higher rates.