Fed Tapering? And What Investors Should Be Mindful Of
Fed acknowledges the need for tapering, but insists the timing of rate hikes is disconnected to tapering.
Investors are caught in a catch 22 situation – they need to protect their portfolio against rising inflation at a time when low interest rates continue to support equity markets.
With increased volatility expected across markets, defensive equities and floating rate notes may serve investors well.
The September Federal Open Market Committee (FOMC) meeting was clearly hawkish. The Fed noted the improvement in the sectors most impacted by Covid-19, and acknowledged the substantial progress towards achieving employment goals while noting that it considers inflation as “elevated”. We expect tapering to be announced at the November meeting unless there is a material change in the data. The message was as expected with the Fed doubling down on their stance conveyed at the Jackson Hole Economic Symposium in August.
Of interest at Jackson Hole, was Powell’s comment; “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test”.1 This reiterated his position on disconnecting the taper timing from the timing of any future rate hikes. Tapering signals normalisation in growth which in turn leads to normalisation in interest rates, and hence future hikes from their current levels. The timing of the hikes is the big question.
So what is the Fed up to?
In the September meeting, FOMC members were split between zero and at least one hike in 2022, and were projecting three hikes in 2023 and 2024. The Fed is trying to maximise employment by keeping rates at record lows to spur demand and trying to solve a problem that is essentially not theirs to solve. Issues around distributional equity have been generations in the making and Fed thinking they can sustainably solve them via lower interest rates during half a business cycle, might become an issue. Especially if, in letting the economy run hot, they mis-step and let it (and inflation) run too hot for too long.
Figure 1: United States Consumer Price Index (CPI)
For investors, higher inflation even if transitory can pose significant downside risks. Equity investments generally face additional headwinds in inflationary environments. In this environment the equity risk premium remains intact, however valuations are now looking frothy. Investors also need to be wary that risks to long growth positions are increasing, with inflation being one source of increased risk in equity exposures. In such a scenario, more defensively styled equity exposures may better position investors for future bouts of volatility. Equity style factors such as Quality & Low Volatility have provided positive real returns during rising inflation.
In multi-asset portfolios, investors have had the cushion provided from bonds. That cushion is provided by the mechanism of yields being able to move lower. However in the current low yield environment, there is very little cushion. The Fed and other central banks have intimated that they are willing to let inflation run hot so interest rates and yields can be expected to remain anchored. This means bond investors additionally need to manage the interest rate sensitivity (duration) of their investments. That is where assets like Floating Rate Notes can potentially benefit investors providing an additional source of yield without the duration risk.
1 Jerome Powell, Jackson Hole Economic Symposium, August 2021.
Issued by State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services Licence (AFSL Number 238276). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia T: +612 9240-7600. F: +612 9240-7611.
The views expressed in this material are the views of Raf Choudhury, Head of Investment Strategy & Research, Australia through the period ended 14 October 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal. Risk associated with equity investing includes stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. This communication is not intended to promote or recommend the use of options or options trading strategies and should not be relied upon as such.
A “low volatility” style of investing can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market.
A "quality" style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on "quality" equity securities are less than returns on other styles of investing or the overall stock market."
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
BLOOMBERG and BLOOMBERG INDEXES are trademarks or service marks of Bloomberg Finance L.P. Bloomberg Finance L.P. and its affiliates (“collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary right in the BLOOMBERG INDEXES. Bloomberg does not approve or endorse this material and disclaim all liability for any loss or damage of any kind arising out of the use of all or any part of this material.
This document may contain certain statements deemed to be forward-looking statements. All statements, other than historical facts, contained within this document that address activities, events or developments that SSGA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSGA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSGA's control. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.
All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA Australia's express written consent.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.