The Federal Reserve is officially signaling a change in its stance on monetary policy and is planning to reduce its monthly bond purchases at a more rapid pace. Following the Federal Open Market Committee (FOMC) meeting on Dec. 15, Chairman Jerome Powell took a more “hawkish” (meaning higher interest rates) stance on the pace of the “taper”. By accelerating the pace of tapering the bond purchases, Powell is setting the stage to begin raising interest rates by perhaps late spring or Early Summer of 2022. In addition, the majority of the Fed officials now believe there will be at least three .25% rate hikes by the end of this year.
The markets seem to have already begun pricing in much of this news but it is still unclear how these two moves by the Fed will affect the markets throughout 2022. With inflation running at multi decade highs and interest rates still near record low, the Fed will have a challenging task ahead.
Inflation is the key factor forcing the Fed’s hands in raising rates. The latest CPI data indicated that inflation is currently around 6.8% on a year over year basis, which is the highest it has been in 39 years.
So what does inflation mean for stocks?
According to the Capital Group (American Funds), what seems to occur is that stocks tend to perform the poorest at the extreme ends of inflation (or deflation). A small amount of inflation is a good thing for companies, as it allows them to raise prices and profit margins. However, when inflation climbs 6% or higher over a rolling 12 month period, stocks tend to suffer a bit more than usual. This makes sense, since higher inflation often means higher input costs, higher loan costs and limited pricing power.
The research team of LPL Financial, led by Ryan Detrick, suggests in their Outlook for 2022 that rate of inflation is expected to recede this year and ease some of these burdens on the markets. In any case, what remains to be seen is how significantly the Fed’s response to this inflation will influence the performance of the markets.
How might the markets react to rising rates?
Interest rates have been abnormally low for a long time now and the big question is: “How will markets react?” Historically a gradual rise in rates have not completely thwarted a bull market in stocks, but in a “fast-tightening” cycle markets tend to do worse.
LPL Research notes that in the previous six rate-hike cycles (1983, 1987, 1994, 2004 and 2015), the S & P 500 has gained on average 9.5% during the six months prior to the first rate hike. Additionally, “value” oriented stocks have generally performed best during these periods. Notably, our “growing dividend” portfolio and “current equity income” portfolio should be positioned well for this type of environment.
Are we due for a market pullback?
Is it possible that rising rates and a richly valued market could cause a pullback in 2022? The second year of a presidential administration is typically the weakest year of a presidential cycle for the S & P 500 (LPL Research).
The combination of these two factors causes our team to suggest to investors we could be in for a more volatile market compared to the past 18 months. Additionally, the first few months in the second year of a Presidential cycle are generally more volatile and uncertain, but the trend has been for recovery in the latter part of the year when there is more political certainty.
The moral of the story is that in an election year, it is important to maintain a long-term focus and not get overly excited with short term gyrations. Over long-term periods of time, the stock market tends to move with the economy and corporate earnings, both of which are expected to grow meaningfully in 2022. We expect more ups and downs in the markets ahead, and we believe comprehensive financial planning, asset allocation, and dynamic portfolio management continue to be the best tools available to prepare for whatever market environment 2022 may bring.