The stock market got a bit choppy after the Federal Reserve's press conference on June 16. The VIX jumped up while major stock indexes dropped following the central bank's commentary. This big market move comes without any major company-specific news or new economic indicators. For the time being, the No. 1 force impacting your equity portfolio is monetary policy.
We know for certain that investors are closely watching the Fed. As talk ramps up about inflation, recovery, tapering, and rate hikes, you should take the necessary steps to ensure that your portfolio can thrive no matter what happens.
What the Fed told us
The Fed changed its tune slightly in June, which caught the market's attention in a big way. The central bank raised its previous forecasts for both economic growth and inflation for the remainder of 2021. Even more importantly, Chairman Powell indicated that they were pulling forward their timeline for raising interest rates. The Fed previously stated that rate hikes wouldn't be discussed until 2024. Now they are prepared to take action a full year earlier, if necessary.
This is welcome language for investors who are worried about price inflation and charging asset prices. It was the central bank's strongest recognition of inflationary pressures since the pandemic started. Still, the Fed's Open Market Committee (FOMC) release confirmed that monetary policy and implementation wouldn't change for now. They were also very clear to point out that they expect inflation to fall next year, and that certain industries and demographic groups remain deeply impacted by the pandemic.
While the recovery is well under way, it's not complete. There's still uncertainty as we normalize and rebuild. The Fed is leaving its options open as it monitors progress.
Why does the market care so much?
It might seem odd that investors were influenced so acutely by an announcement that the Fed might make slow, modest adjustments to policy in two years rather than three. It's hard to say that any meaningful changes have been made to the revenue and profit outlook for stocks you own. It might seem odd, but the fuss is really about where capital will flow when a rate hike occurs.
Rising interest rates will have two immediate impacts. First, Treasuries and other low-risk bonds will have higher yields. Investors will jump at the new opportunity to get improved returns without the risks posed by equities. Some capital will flow away from the stock market as a result. Second, businesses will no longer receive the same direct support from monetary policy. This might not actually impact the majority of companies, which should be able to survive on a fundamentally strong economy. However, it will still plant a seed of concern in some investors, again causing less capital to flow into the stock market.
Those dynamics should cause a modest, temporary downward adjustment in stock prices. However, investors are aware of this ahead of time, so many will try to adjust their portfolios in anticipation of the market's reaction. Don't want to be caught holding high-valuation growth stocks when a mini bear market starts? The obvious solution for active traders is to sell them to move into cash and less volatile stocks. They can then purchase bonds at higher interest rates or get back into stocks after their prices drop.
This knock-on effect of rate tightening just exaggerates the situation. The Fed raising rates should be a signal that the economy is strong. Gradually rising interest rates shouldn't hurt businesses in any meaningful way. The whole disturbance is a short-term reaction in capital markets, with traders looking to capitalize on those adjustments. That's important to recognize if you're a long-term, fundamental investor.
How to manage your portfolio through tapering
So how do we build an investment strategy that's set up to handle all of this disturbance from monetary policy?
The first step is to prepare yourself for inevitable volatility (and the probable market dip). If the Fed gets its way, then they'll be able to raise rates without much impact on stock prices. They'll hope that good economic news and corporate financial results will be so strong that higher interest rates won't matter. Stock indexes are at all-time highs thanks to charging valuations. We're almost definitely counting down to a small market downturn, and last week's reaction to the Fed announcement is evidence of that. Make sure that you're emotionally prepared for a dip, and don't make any panicked decisions when that day comes. Be ready to ride this out for the long term, because this interference will be temporary.
It's also a great time to review your allocation. If your whole portfolio is composed of growth stocks, then congratulations on the great returns you've enjoyed over the past 15 months. It might be a good time to take some of those gains and redeploy them into stable value stocks or Dividend Aristocrats. If you have a short investment time horizon, make sure your portfolio has the right allocation of bonds. That refers specifically to retirees and people approaching retirement. Don't expose yourself to too much volatility.
This isn't to say that you should get away from growth stocks entirely. It might take more than a year for the next "taper tantrum" to occur. It might not even be a large drop, depending on how things shake out. That's why it's safe to cover all your bases. If you're a long-term investor who prioritizes growth, you might not need any adjustments at all. Just be ready to ride out the storm.