New Policies and New Expectations
This past week was particularly newsworthy, not just with the release of various economic datapoints, but from significant policy drivers as well. The good news is these were largely cheered by the markets. The S&P 500 finished the week up 2%, with small cap stocks, as represented by the Russell 2000 Index, gaining +6.1%. Bond yields fell, so it was a positive week for both stocks and bonds.
On the economic front, we saw data indicating generally favorable industrial activity during October. On Friday, the monthly employment report showed more job gains than expected, with the unemployment rate ticking down to 4.6%. On the policy front, the Federal Reserve met and announced they would begin to slow their pace of monthly bond purchases (i.e. tapering) beginning in November. They also outlined a path to completely exit their quantitative easing program by July of 2022. This is a significant shift as the Fed has been a sizable presence in the bond market since March of last year. This week also saw approval of a new therapy from Pfizer that can be used to treat COVID symptoms, adding more ammunition to fighting any future flare ups from the pandemic. Lastly, late Friday the House of Representatives approved a bipartisan infrastructure bill that will go to President Biden to be put into law. This adds another leg of stimulus, albeit spending that will be spread over a number of years.
These new policy drivers are bound to make investors reconsider how they might influence future expectations. More confidence that COVID may be increasingly behind us is a good thing for sustaining consumer confidence. Added fiscal stimulus from the infrastructure bill will create additional multi-year demand to the economy. Furthermore, less accommodative policy from the Fed may lower the risk appetite among investors that felt the Fed’s involvement in markets supported greater risk taking. Taken together, these drivers may lead investors toward diverging expectations around the most attractive return drivers going forward in the market.
An example of this came this week in the bond market. Following the Federal Reserve’s meeting, bond yields fell on Thursday and Friday. Going into the Fed’s meeting, expectations for future Fed rate hikes in 2022 had grown. In fact, the market implied probability for three rate hikes in 2022 was over 80% going into the meeting. In his post meeting press conference, Fed Chair Powell came across more patient on the need to raise rates, pouring cold water on these expectations. This was followed by the Bank of England, who on Thursday kept rates steady even though markets expected the central bank to make its first rate hike.
Ultimately, it seems highly likely that interest rates will be heading higher, likely at some point in 2022. Longer-term, whether the Fed raises rates two or three times in 2022 doesn’t matter all that much. In the end, direction of rates is higher. This will not only have an impact on the bond market but will impact stocks as higher yields may appeal to some investors that may choose to shift some of their portfolio back to bonds after having elected to take on more risk in stocks in search for return. We think a shift in policy may also spur other investors to reconsider where they see attractive returns going forward in this shifting economic landscape. It’s possible more highly priced growth stocks may not be as attractive as ‘old economy’ infrastructure and financial stocks that stand to benefit from the infrastructure bill and a less accommodative Fed.
Gauging investor sentiment and how others will react can be challenging in the short-term. In this environment, where there are clear shifts in policy, we believe taking a long-term perspective and not focusing too heavily on what’s worked in the past, when policies were different, may be the prudent road to take for the journey ahead.
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