‘Wall of Worry’ Casts Shadow Over Markets in Q4

The monetary policy outlook is no longer unequivocally bullish for stocks. The Federal Reserve is close to starting to “taper” by reducing its purchases of government and mortgage securities.

Tapering is likely the right thing to do, as Fed intervention in the bond market may now be causing distortions that do more harm than good. The market reaction to the Fed’s recent meeting — with the 10-year Treasury reaching 1.5% before quarter-end — was more about the path for raising rates than about the taper.

Although the odds of a 2022 rate increase have risen, slowing employment growth may delay the Fed’s path to normalizing interest rates. Inflation is proving to be stickier than the Fed projected over the summer, but supply chain and labor bottlenecks are likely to fade over time. 

Trends in wages and rents are potential threats to the expectation that inflation pressures will ease next year. In contrast to a relatively positive near-term outlook for inflation, investors should prepare for moderately higher long-term levels of inflation because of deglobalization, aging demographics and a move to just-in-case supply chains replacing just-in-time supply chains. 

Fiscal policy is a divisive topic among investors, with some forecasting that the economy will overheat because of big spending packages while others forecast a growth slowdown because the expiration of pandemic spending programs will create fiscal contraction in 2022. However, the Biden administration’s spending plans are likely to be lower than initial projections and, if passed, will be spread over many years. 

Any fiscal contraction in 2022 will likely be less severe than worst-case scenarios, given that much of last year’s spending was income replacement rather than pure stimulus. Brinkmanship over the debt ceiling may contribute to market volatility in the coming weeks, but a government shutdown will likely be avoided. 

The “wall of worry” is enough to raise market volatility, but the outlook for equities remains positive. Although economic growth is slowing from the torrid levels of earlier in the year, economic growth in 2022 is likely to remain above pre-pandemic levels. Equities offer greater value than bonds; unfortunately, the “easy” equity gains from reopening have been made. 

Diversification within the equity portfolio continues to be important because rotational shifts experienced in recent years are happening so quickly. Diversification must be emphasized not just across sectors, but also across market cap, geographies, asset classes, and within asset classes. Just as important as diversifying is thoughtful rebalancing to trim back on areas that have outperformed and add to areas that underperformed.

 Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston. Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds. Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the board of trustees for the Green Century Funds.