What 'Tighter Monetary Policy' Means and What Investors Should Do About It
If you have been paying attention over the last few days, I am sure you are aware that the Fed will conclude their regular meeting today, after which they will issue a statement, and Chair Jay Powell will give a press conference. Almost all economists, analysts, and Fed watchers believe that this time around, those things will be significant. The central bank is expected to move away from their view that inflation is transitory and signal a change to tighter monetary policy. However, if you are relatively new to investing and/or aren’t consumed by it every day, you are probably nodding your head at that, but at the back of your mind are two questions: What does “tighter monetary policy” actually mean and, more importantly, what does it mean for my investments?
Tighter monetary policy will be achieved by doing two things. The first is to reduce the amount of asset purchases the Fed is currently making. Since the middle of last year, the Fed has been buying over $100 billion worth of Treasuries and mortgage-backed securities from banks each month and doing so with money that they essentially just create for that purpose. That was their response to the economic chaos engendered by the pandemic, and it has two effects.
The first is to provide liquidity to the banks, meaning that they have a lot of cash available to lend out to individuals and businesses or with which to buy stocks or make other investments. That promotes growth and underpins the stock market. The second is that it keeps interest rates on longer-dated bonds low. The Fed sets rates for short-term paper, but long-term rates are set by the market. By buying massive amounts 20 and 30 year-to-maturity securities, the Fed forces prices up on those longer-term bonds and, in the topsy-turvy world of bonds, higher prices equate to lower yields or rates.
Powell is expected to announce that the Fed will reduce the amount of their regular purchases significantly and lay out a path to eliminating them, while also giving an idea of when and by how much they intend to raise rates to combat the now sticky-looking inflation.
So, if the banks are going to have less money to invest in stocks and economic growth is going to be deliberately slowed by raising rates, the answer to the question of what that means for your portfolio would seem to be "disaster," right?
Well, not necessarily.
First, drastic changes to a long-term portfolio are almost never a good idea. You are usually much better off just riding through the ups and downs. In addition, none of this will come as a surprise to the market. It has been expected for some time so, assuming that there is no drastic acceleration of the expected timetable of three rate hikes of a quarter of a percent each starting in the middle of next year, much of it is presumably already priced into stocks, even though we are not far off the highs.
This is, therefore, not the time to take drastic action within a long-term portfolio, but there are a few tweaks that investors should consider.
First, think about why this is happening. It is because of inflation, so moving towards stocks in companies that have strong pricing power makes sense. An example might be Apple (AAPL), where customers have consistently shown themselves not to be price sensitive. If inflation continues, then commodity producers will benefit, too. Energy and materials companies will not see big increases in costs but will be getting more money for every barrel of oil or ton of metal they produce. They are a good place to hide for a while if the Fed does as is expected, even though slower growth will hurt demand somewhat.
Simultaneously, holdings in companies that will face rising input costs but where customers are very sensitive to price should be trimmed if not sold outright. That would bring in consumer discretionary stocks such as Coach and Kate Spade parent, Tapestry (TPR) and other luxury goods companies along with most auto manufacturers, for example.
Another area where adjustments should be made is in anything that derives a large part of its value from dividends or other regular payouts. If bonds will be offering higher interest payments, the relative value of other yield-based investments will fall, so things like utilities and REITS will be less valuable on a relative basis.
Even though we all think we know what Jay Powell will say today, there could be a quite dramatic reaction when he actually says it, particularly if there is anything in his words that hints at faster than currently expected adjustments to policy. That makes it important that investors go into today with a plan. Having one stops you from being panicked by short-term volatility into making moves that make little long-term sense and stopping yourself making bad decisions is an essential part of successful long-term investing. Tighter monetary policy is coming, and after an extended period of historically loose policy, it may come as a bit of a shock, expected or not. However, if you understand what it actually means and make a few minor adjustments to your portfolio based on that knowledge, you should be able to ride it out and focus on your long-term goals.
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