When the pandemic started, the Fed slashed interest rates and began buying $120 billion a month in bonds and mortgage-backed securities to reduce interest rates, lower borrowing costs, and give businesses and the economy a boost. The move worked. With this easy monetary policy and a spike in consumer demand coming out of the recession last year, company earnings and profits have been looking really good. It is easy to see why the market has been doing well so far this year. However, there has been a lot of talk recently about tapering. Let’s dig in to what this means and how it may affect investors.
What does “tapering” mean?
In economics, tapering refers to winding down the pace of “Quantitative Easing” (QE). QE is a tool that the Fed and other central banks use to increase money in the economy. They do this by buying securities from banks, just like you would. Essentially, the Fed buys treasury securities, mortgage-backed securities and corporate bonds. When they do this, they put more cash into the markets and interest rates get driven down. This stimulates growth by making it easier for companies to access capital.
Since QE is a crutch to help the economy grow, at some point it makes sense to take the crutch away. Many are speculating right now that our economy has reached a point where stimulus is no longer needed, and the Fed should start “tapering” their bond purchases.
What happens when the Fed tapers?
The closest comparison that we can look at to know what to expect is the Fed’s tapering in 2013. This was when the central bank began to reduce their stimulus following the Great Financial Crisis of 2008. At the first mention of tapering in 2013, there was a steep selloff in bonds and stocks began to fluctuate with more volatility. At the time, this was a shock and became known as the “taper tantrum.” However, looking back, we can see that the 2013 taper tantrum wasn't even that bad. The S&P 500 tumbled 5.8% over the course of a month but quickly recovered (the caveat here is always this: the past does not predict the future). It’s not 2013, it’s 2021 and we have been through this before. We have the benefit of knowing what to expect.
Source: Fidelity. Third Quarter 2021 Quarterly Market Update
The main reason folks worry about the Fed reducing support is because of the effect that higher interest rates could have on stocks, particularly companies that rely on borrowed money. However, interest rates are just one piece of the puzzle. Economic fundamentals, earnings, and other factors also weigh on stock prices.
What should we expect?
Last week, Fed Chairman, Jerome Powell, confirmed that “it could be appropriate” to start tapering and many predict that this will begin in November [1]. However, the Fed isn't going to stop buying assets and raise interest rates immediately. It's going to gradually remove the support and see how the economy reacts. While we have seen strong economic recovery, there is still a lot to balance right now before things are given the all clear. Here are some things that economists are watching:
Unemployment is still high: The employment rate has improved, but we just received a report that fewer jobs were added in August than expected. This is likely due to the spread of the Delta variant and will most likely affect the timing of tapering as achieving full employment is part of the Fed’s mandate.
Supply chain is still stuck: There was a consistent message on corporate earnings calls this quarter: Supply issues are limiting expectations for higher growth. This issue will likely improve with time but may last longer than expected. Consumer demand for goods skyrocketed over the last year and has kept sales high, but higher costs have driven prices up and we are still waiting for some equilibrium.
The chart below shows transport rates on containers exported from Shanghai. As you can see, before last year, rates had ben consistently stable. We are in the middle of a demand shock right now. This is mainly driven by consumers spending going away from services and toward goods.
Source: Money Scoop by Morning Brew. 09/02/2021
Still waiting on infrastructure spending: If monetary stimulus is decreasing, the economy could benefit from a hefty dose of investment into infrastructure projects. Many industries are looking forward to a boost that the infrastructure package may bring, and analysts show that the growth multiplier from infrastructure spending will likely offset any tax drag.
Source: Fidelity Investments. Third Quarter 2021 Quarterly Market Update. Multipliers are rough estimates of how much a dollar of spending or tax changes would impact GDP, based on historical averages. Sources: Congressional Budget Office, Richmond Federal Reserve, Fidelity Investments (AART), as of 6/30/21.
What should we do?
None of us know how changes to policy will really play out. We can look to the past, but there will always be new scenarios to consider. Most, if not all of this discussion is completely out of our control. What we can control is our investment process. It is important as ever to stick with the fundamentals. Asset allocation, diversification, and rebalancing. We can be smart investors instead of emotional investors. We can use common sense and invest in quality. We have a plan that accommodates market volatility, and we should be able to shrug off any “tantrums.”
There is a lot of good news right now to consider as well! We just finished a strong quarterly earnings season. Most of the calls that I listened to were extremely positive! The fun part is listening to how companies are looking at the future. It seems bright with innovation! We are fortunate to be living right now and we have a lot to be grateful for.
Need to discuss your investments? We are always happy to chat and answer questions. You can schedule a call here.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.