Equity market leadership has historically undergone a significant rotation when the Federal Reserve starts raising interest rates, with Value tending to hold up better than Growth and small caps initially coming under pressure, according to Barclays.
The analysis comes as financial markets increasingly price in the possibility of a Fed rate increase by the first FOMC meeting of 2027. That shift has occurred even as expectations for inflation over the near and medium term have eased.
Barclays economists remain more cautious about the prospect of tightening and expect no rate increases during the first half of 2027. Recent inflation readings, they said, should be “sufficiently benign to keep most FOMC members on hold pending further evidence.”
Energy leads before the first Fed hike
To assess the potential market implications, Barclays examined five tightening cycles going back to February 1994 and compared sector and factor performance immediately before and after the first rate increase.
According to the bank, “the onset of a Fed hiking cycle has historically marked a clear inflection point for equity leadership.”
The S&P 500 generated a median return of 2.2% during the three months before the first hike, while small-cap stocks delivered roughly flat performance.
Energy and Industrials stood out during the run-up to higher rates, each recording median gains exceeding 7.5%. Communication Services moved in the opposite direction, falling approximately 2%.
Financials suffer once rates begin rising
The historical picture became less favourable after the first rate increase. The Russell 2000 fell by a median 7.2% during the subsequent quarter, considerably worse than the S&P 500’s median decline of 3.9%.
Financials were the weakest-performing sector, posting a median loss of 8.4%. Health Care, Utilities and Consumer Staples also struggled, despite their traditionally defensive characteristics.
Energy proved the exception, generating a modest median gain of 0.3%.
Barclays said Financials can be hurt by the combination of tighter financial conditions and flattening yield curves, which weigh on lending margins. Defensive sectors have also historically experienced valuation pressure when a rate increase signals confidence from policymakers that the economy can withstand tighter monetary conditions.
Value advantage strongest among small caps
Within style factors, Barclays found that Value has “generally fared better than Growth, especially within small caps.”
Large-cap Growth historically trailed Value over the two quarters following the first rate increase. Among smaller companies, the difference was greater, with the shift “even more pronounced among small caps, where Growth trails Value sharply within the first two months of the hiking cycle.”
Momentum typically performs strongly in advance of the first hike but becomes more range-bound once tightening is underway.
The Fama-French small-over-large factor has also tended to weaken during approximately the first two months of a hiking cycle, before subsequently entering a more sustained recovery.
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