Fed Closer to Acting

by Peter Thoms, CFA, MBA

August 17, 2021

Despite the challenges to investor sentiment in recent weeks, U.S. stocks have been resilient and unwilling to retreat much from their all-time highs. Strong corporate earnings and a broad recovery in consumer spending have buoyed markets, leading to strong performance for U.S. equity indexes so far in 2021. In our opinion, markets face two major risks in the near term.

We think that by far the most important challenge for markets over the next year will be stomaching a Federal Reserve that shifts from being accommodative to markets, as it is now with its low interest rate policy and bond-buying efforts, to being more hawkish in its monetary policy stance as economic growth continues and inflation heats up.

Changing Role for the Fed

In recent years, investors have become accustomed to a Fed that races to the rescue every time there is a hiccup in economic growth or employment. In the coming months, however, strong economic data may force the Fed to focus more on containing nascent inflation rather than continuing to support an economy that no longer needs its help. If our economy manages to push through a Delta variant-induced speed bump to resume strong growth toward the end of 2021 and into 2022, the Fed will probably have no choice but to begin to unwind its supportive policies. Since our emergence from the 2008-2009 financial crisis, investors have only known an accommodative Fed. Thus, what has been a Fed tailwind for the last decade may turn into a Fed headwind for investors, and how they respond to the Fed’s new role will have strong implications for the performance of investments from across the spectrum of bonds to stocks to real estate. Chairman Powell and the other Fed governors will have to adopt a gentle and soothing tone for investors if they want the markets to stay on track as the Fed changes its role.

Will Delta Slow the Recovery?

The second main risk to equities in the near term is the impact of the Delta variant on the recovering global economy. While Delta is apparently more transmissible than other mutations of the virus, it has fewer pathways through which to propagate as people either get vaccinated or gain some natural immunity by contracting COVID itself. Nevertheless, the summer spread around many parts of the U.S. led to a stunning drop in consumer confidence between July and August. The University of Michigan Consumer Sentiment Index registered one of its largest-ever monthly declines from a reading of 81.2 in July to a preliminary reading of 70.2 for August, which was below even the pandemic low of 71.8 in April 2020. In the past 50 years, the Index has only recorded a bigger monthly drop on six occasions. Clearly, American consumers have come to realize that the pandemic is not close to being over and further travel restrictions and lockdowns could be in the cards. While the travel and leisure sector has seen reduced forecasts over the past few weeks as the Delta variant spreads, the broad stock market has not seen discernible impact from Delta. Why? Perhaps investors have seen this movie before and are now confident that our economy and capital markets will power through whatever roadblocks Delta throws up.

Growth Likely Peaking

Despite recent souring consumer sentiment, other economic indicators such as employment and GDP growth continue to be firm. Corporate earnings have grown massively year-over-year as they lapped the terrible numbers in the first part of the pandemic. Both consumers and companies now sport very strong balance sheets. The S&P 500 Index, from the pandemic lows in March 2020, has vaulted nearly 100%, the fastest bull market rise since World War II. Now, however, economic growth and earnings growth are likely peaking, and investors would be prudent to prepare themselves for both less gaudy growth rates going forward and diminishing support from the Fed.

Please contact us if you would like to discuss your portfolio or the financial markets.

Image: fstockfoto via Canva.com

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Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.