UBS: Investors shouldn't fear a Fed rate hike — earnings growth remains the main driver of stocks

Based on UBS's assessment, investors shouldn't fear the interest rate hike expected from the Federal Reserve (Fed) this week. The bank points to historical data showing that stocks typically remain resilient after the start of a monetary policy tightening cycle.

UBS expects the Fed to raise rates on Wednesday, though it believes the key factor for the stock market will not be the first rate hike itself, but rather corporate earnings growth. The bank has kept its year-end S&P 500 target at 8,100, with a mid-2027 target of 8,400.

According to UBS strategists, including David Lefkowitz, across the 16 rate hike cycles recorded since 1954, the S&P 500's average gain in the 12 months following the first hike was 10.8%. They note that during this period, the index has never entered a "bear market" within the 12 months following the start of a rate hike cycle.

The strategists point out that for stocks, the state of economic growth matters more than the rate hike itself. In their assessment, the ISM Manufacturing new orders component best explains how subsequent stock returns evolve following rate hikes.

Currently, the US manufacturing sector remains in an expansion phase, and according to UBS's forecast, growth in AI investment will continue at least until 2027. The bank believes the current environment is more consistent with continued economic expansion than with recession. Per UBS's latest assessment, the ISM Manufacturing PMI has been in expansion territory for eight consecutive months.

UBS also notes that a significant portion of the valuation compression caused by monetary tightening may already be reflected in the market. The S&P 500's forward price-to-earnings ratio (forward P/E) has fallen from around 22 at the start of the year to 19.5, as the 10-year US Treasury yield approached the 5% mark.

The bank does not expect as aggressive a tightening cycle as in previous periods of fighting inflation. According to UBS's assessment, a significant part of the rise in inflation is linked to temporary factors, which reduces the need for the Fed to pursue a prolonged and sharp tightening.

At the same time, UBS considers investment in AI infrastructure to be one of the main risks for the market in the medium term. However, the bank believes that financing conditions would need to tighten significantly more than is currently expected for high interest rates to become a serious constraint on AI infrastructure investment.