At its November meeting, the Fed tacitly acknowledged its tardiness in taking action to harness the overheated economy. It decided to gradually reduce its purchases of Treasury and mortgage securities over a period of six months, a prelude to hiking interest rates. It pays for these securities by debiting the Fed account of the bank or brokerage firm processing the sale. That is to say, it prints the money. In promising to print less new money this month than last month, the Fed is still pursuing monetary expansion, but at least it admitted that a new direction is called for. The Fed is also haunted by the 2013 “taper tantrum” when it induced market convulsions while trying to reduce, or taper, similar purchases.
At its December meeting, the Fed decided tapering over six months was being too patient. Instead, it would wind down purchases by March according to the announcement following the meeting. After ceasing new purchases, the Fed will likely vote to increase short-term interest rates, the first of three rate hikes anticipated in 2022. When minutes of that meeting were released in early January, investors discovered that the Fed is also considering shrinking its bloated balance sheet by not reinvesting proceeds from maturing securities. That’s when investors began to realize the Fed is serious about slowing the economy in order to reduce inflation.
Equity investors don’t like to hear about “slowing the economy.” Economic growth is good for corporate sales and profits, even if some inflation is involved. But when inflation runs too hot for too long, the Fed ends up slamming on the brakes rather than gently tapping them. In fact, the Fed has a history of hitting the brakes harder than equity investors would like. Hitting the brakes can induce a recession, investors’ greatest concern. Tapping early is better than slamming late.
The impact of the Fed’s pullback in bond purchases is evident in the market. Treasury yields have gradually risen to their highest levels since before the pandemic. Even still, the 1.85% yield for a ten-year Treasury doesn’t seem like adequate compensation when inflation has been running 7%. That equates to a “real” yield of -5%. We are surprised rates aren’t higher still.
Equity investors need to be cautious given the Fed’s growing realization it has fallen behind and its determination to make up for lost time. But where else can we turn? Bond yields will likely go up, causing prices of existing bonds to decline. Yields are already lower than inflation. Build up cash? Bank, CD, and money market yields are virtually zero, or -7% in real terms. Commodities? Not a good answer since they will likely bear the brunt of any economic slowdown.
Our approach is to remain fully invested most of the time, even when it is uncomfortable. We look for opportunities to make shrewd investments when the market turns choppy, setting ourselves up for success when the market stabilizes and goes on to new highs. In our February 2022 issue, for instance, we made three recommendations for subscribers -- a software infrastructure company, a gaming software business, and a medical devices maker. Each of these companies are positioned to perform better than the broader market over the next several years.
The lack of appealing alternatives to equities in general suggests staying the course. But the captain has turned on the seatbelt sign as we have some turbulence ahead so please remain in your seats.
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