The decisions made at the December Federal Reserve (Fed) meeting began a new journey since the unprecedented steps taken after the financial crisis of 2008. The Fed had flooded the economy with enormous liquidity by expanding its balance sheet by almost $800billion in the last 5 years. Source: WSJ. At the last meeting, the Fed finally pushed the tapering button, which would slow down (taper) its historic stimulus program called Quantitative Easing (QE). These monthly bond purchases (QE) have supported low rates, higher stock prices and the economy. What happens next for investors?
Given the start of a new era in the Fed’s books, here are some key takeaways for an investor:
1) Bonds: The bond market was little moved by Fed’s action last week. . Let us compare that to this past summer when the Fed had announced (not acted) that they would start slowing down its stimulus program. The bond market corrected with the 10 Year Treasury rising from 1.6% in May to 2.9% by September. Now, when the Fed acted, the bond market barely moved as the 10 Year Treasury stayed around its previous day’s levels. Source: WSJ. The disparate movements in the bond market over the last few months show that as an investor, one cannot be complacent about their bond portfolio. Active bond management and a careful review of the portfolio are important factors to consider.
2) Confidence in the economy: Over the last five years, the money in-flow by the Fed helped spur the economy and supported the stock markets. The Fed had said earlier that it would not start reducing support until it believed the economic recovery had legs. The fact that the Fed decided to start slowing shows its vote of confidence for the economy. At the meeting, the Fed also mentioned that their actions will be economic data dependent and that they will stand to support to the economy if needed. As an investor, this may mean that tapering may be slow and it raises confidence that the economic recovery is real. One may consider investing in parts of the economy that are showing signs of strength.
3) Fed Policy errors? Many investors remain wary of possible future errors that the Fed may make. They fear that the Fed stimulus was an unprecedented effort that may bring high inflation. Should an investor twist portfolios now in anticipation of uncontrollable inflation brought by potential Fed policy errors in the future? Currently, the inflation levels are quite low, way below historic inflation. The economic slack, both in this economy and globally, suggests that it may take a long time and a lot of error on the Fed’s part before anyone has a need to cope with excessive hype and certainly a generalized acceleration in inflation. The Fed could use this long hiatus to reduce the excess stimulus gradually. Investors, consequently, may have ample time to position their portfolios for any failure on this front. Hence, it might be too premature for investors to hedge against inflation.
The stock market rejoiced in the Fed’s decision last week. Long-term investors may consider the Fed’s decision as a step towards a normalized world, as it is a sign of a vote of confidence in the economy. As the historic unwinding of Fed’s stimulus gets underway, one should focus on its impact on portfolios and look for potential opportunities arising from this. Staying diversified in bonds and equities remains the main mantra in a world, which is trying to return to normal.
Wishing you and yours a Happy Holiday Season.