Equity performance tends to shift as the Federal Reserve prepares to raise interest rates, with small-cap stocks and energy sectors leading gains in the months before the first hike, according to a Barclays analysis of five past tightening cycles dating back to 1994.
In the three months leading up to the first rate hike, the S&P 500 posted a median gain of 2.2%, while small-cap equities were roughly flat. Energy and industrials were the strongest performers, each delivering median gains of more than 7.5%. The communication services sector was the sole decliner, falling about 2% in the pre-hike period.
The pattern reverses once tightening begins. In the quarter following the first rate hike, the Russell 2000 small-cap index posted a median loss of 7.2%, while the S&P 500 declined 3.9%. Financials fared worst among sectors, with a median return of -8.4%. Energy was the only sector to post a gain, rising a modest 0.3%.
Barclays economists do not expect any Fed rate hikes through the first half of 2027, though market pricing has shifted toward a potential increase by the first FOMC meeting of 2027. Recent inflation data has been described as "sufficiently benign to keep most FOMC members on hold pending further evidence."
Style factors also exhibit distinct patterns around rate hikes. Value generally outperforms growth, particularly within small caps, where the rotation is more pronounced. Growth underperformed value over the two quarters following the first hike among large caps, with the gap widening further in small caps within the first two months of the hiking cycle. Momentum factors tend to lead into the first hike but become range-bound afterward.
The Fama-French small-over-large factor weakens for roughly two months post-hike before recovering. Financials’ underperformance is attributed to tighter financial conditions and a flattening yield curve that pressures bank lending margins, while defensive sectors such as health care, utilities, and consumer staples suffer valuation de-ratings as the Fed signals confidence in a strong economy warranting higher rates.
The onset of a Fed hiking cycle has historically marked a clear inflection point for equity leadership, with sector and style rotations often persisting for months after the first move.
