While U.S. equity markets have enjoyed a favorable 2021 to the point of this writing, more recently volatility has started to rise. Markets are in the process of digesting several key factors such as inflation, tapering, interest rate direction, and economic growth both here and abroad. The path these data points take in the next 12-18 months will play a role in the future direction equity and bond markets move.
During his testimony before Congress, Federal Reserve President’s Jerome Powell offered up the thought of retiring the term “transitory” when thinking about how long inflation will remain at elevated levels. This is due in part because the term, when used as a measurement for time, can mean different things to different people. We think that prices will remain elevated for goods and services going into 2022, and we have raised some of our long-term assumptions for inflation to take this into account. We also believe the level at which prices rise further could begin to subside as we move into the latter half of next year.
During this same testimony, Powell also commented that the Federal Reserve could quicken the pace at which they taper their asset purchase program. Doing so would decrease the amount of assets the Federal Reserve would be adding to their balance sheet, with the hope of eventually getting to zero. This program was originally put in place as a stimulative measure to suppress interest rates and increase the money supply. We could see interest rates increase over time if buyers do not move into the marketplace to replace the Federal Reserve’s buying. In fact, during the fourth quarter we started to see interest rates move higher on the short to medium term part of the yield curve in anticipation of the Federal Reserve completing the taper of their asset purchase program.
The next tool at the Federal Reserve’s disposal to combat inflation would be raising the Fed Funds Rate, or the overnight lending rate between banks. This would work to help the Federal Reserve meet their dual mandate of maintaining stable prices and maximum employment. The economy is currently running hot; if they believe it becomes too hot and prices keep climbing, they may take this step in an attempt to reign in the economic growth to more sustainable levels.
The Federal Reserve is at an important transition point in 2022. Often investors believe that when inflation is low, it will remain low or turn negative, and when it is high, it will remain elevated. We think that the greater likelihood is that it will moderate, perhaps at a higher level than what we have been accustomed to for the past twenty years. With interest rates in many sectors of the fixed income markets sitting near lows, we must consider what the long-term total return expectations will be for this asset class. The returns the bond market has seen over the past thirty to forty years may be very challenging to match.
The Federal Reserve is at an important transition point in 2022.
U.S. equity markets to date have enjoyed another solid year. Geographically, the U.S. outperformed its peers internationally and in the emerging markets. Performance in the U.S. has been more balanced this year between growth and value, growth with the slight edge. However, we have seen the more traditional value sectors of Energy and Financials perform quite well. Energy has benefited from higher prices for commodities, and Financials from higher interest rates and a steeper yield curve. Both sectors have benefitted from the outlook for stronger economic growth.
2021 has been a year where equity markets have carried the baton for performance, while returns in the bond market have been tougher to generate, acting as a volatility dampener. This is why it is important to view your portfolio through not only your return, but also the lens of your risk tolerance, as well as the amount of volatility you are willing to incur.
In the equity markets, valuations remain elevated versus traditional metrics as technology has become a greater percentage of what makes up the U.S. equity markets. Technology now has a hand in every sector, and not in just what we think of as the technology or communication services sectors. Operationally, many U.S. companies are operating efficiently with profit margins at or near all-time highs. Forecasts into 2022 are for continued strong revenue and earnings growth in the U.S. With the forecast for good economic growth domestically, there is a level of uncertainty about how the equity market will cope with some of the lingering risk out there. For that reason, we feel it is prudent to maintain a diversified portfolio with exposure both here and abroad as well as across the market cap structure. We always keep in mind how the current situation may change our long-term thinking and how we may need to act accordingly.
Understanding an investor’s risk/reward tolerance is a must. Therefore, we feel it is paramount clients maintain the appropriate risk-based asset allocation. Investors vary in the amount of risk they are willing to take on in return for a specific level of return. As volatility rises, we, as investors, often put a bigger magnifying glass on the risk part of this equation.
How can we train ourselves as investors to become better at keeping perspective? How can we avoid letting our short-term emotions affect our long-term goals? While individuals may have different methods for addressing these questions, it is often simply about maintaining perspective. In the moment, we feel the decisions we are making are some of the most important. They consume us. This can lead to irrational choices. Keeping it simple and not getting lost in the potential endless outcomes generally leads to a better decision-making process. Pushing the noise/bias of media to the side, helps us form viewpoints that are longer term in nature which can then be adjusted if needed as economic data is received. Focusing less on what will happen tomorrow or next week allows us to stay focused on our positions with our long-term thesis and how they could be affected by shifts in the economy.
Thinking about some of the most important decisions we have made, I can safely say that our decisions made and the related risks we took on had little or nothing to do with current events. Risks are around us all the time. Major events with unknown outcomes will always be present. As investment managers, we ask ourselves if the impact of what is happening in the economy affects our thesis for positions in the portfolio. If we do not believe our long-term thesis will be impacted, then we will maintain our position, continue to watch, and continue to evaluate. However, if we feel our long-term thesis is impacted by current actions or ones that may be forthcoming, we will take the appropriate steps and act accordingly.
Have conviction. Act with purpose.
In many facets of our day to day lives, time is not on our side. When it comes to being invested, time is our friend.
As we gather with family and loved ones this holiday season, consider the rewards which surround us and the road we took, no matter how winding, to achieve that which we cherish.
If you have any questions or concerns, please contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.