26 October 2021
The COVID Delta wave is starting to fall, and in response, the US Federal Reserve has indicated that it will begin to ease off on its pandemic levels of asset purchases from December 2021 through to mid-2022.
This easing process is what’s commonly referred to as “tapering”: it occurs when central banks begin to reduce their large-scale asset purchasing, or taper their stimulus money printing, and is usually in response to higher inflation and stronger growth.
In this case, tapering is the Fed’s first step to tighten monetary conditions and cool down the economy, with the next step being to raise interest rates, likely from the end of 2022. Now, some investors are concerned that tapering will lead to increased market volatility in the near future.
Below, we cover how tapering may affect the markets and what it means for investors.
There’s a common misconception that tapering means that the central bank is selling off its assets. But it’s actually not about selling assets: rather, it’s about buying less than they were.
To better understand the extent of the upcoming tapering, let’s put the US’s most recent stimulus spending into numbers:
Since the height of the pandemic, the Fed has been buying about $120 billion USD worth of assets each month. It’s estimated that it’ll start buying $15 billion USD less per month over 8 months. So, they’re still buying assets - just less of them.
The Fed is basically trying to minimise the risk of the economy overheating so that it can ultimately reduce the risk of inflation, asset bubbles, and market crashes.
This tapering helps to normalise economic conditions, and that certainly is in the best interest of long-term investors: A stable economy can reduce uncertainty and speculation in the markets, making investors more likely to make rational, not emotional, investment decisions and take on appropriate risk.
The Fed is reacting to a stronger economy and higher inflation, and this upcoming tapering is proof of that.
So to understand how assets will perform in a tapering, we also need to look at what generally happens in a strong growth and inflation economic environment. Here’s what we can anticipate:
Most bonds issue a fixed coupon payment, and this payment becomes less attractive when interest rates rise.
In a high interest environment, investors may find better returns on their cash elsewhere, such as in a high-interest savings account, resulting in lower bond values in nominal terms.
During a stimulus program, central banks pump money into the economy by buying large-scale assets. Banks and businesses, in turn, borrow this money to expand their operations.
This increased spending often results in investors buying more company stocks, as these investors anticipate higher company revenues, and hence, income growth.
And since the Fed is still spending - but less than before - it’s possible that equity prices will continue to rise, but at a slower pace than before.
Some sectors particularly benefit from inflation, such as natural resources and real estate.
Natural resources, which are rich in emerging markets, are positively correlated to inflation: Their prices are likely to rise as they move through the economy in the form of housing, food, fuel, and more.
Real estate prices also tend to appreciate as more investors turn to this sector to hedge against rising inflation.
Economic environments inevitably change, and central banks work to stabilise growth and inflation in the face of those changes. They do so by implementing new monetary policies, such as stimulus programs and taperings, so it’s important that your portfolio is ready to withstand these measures whenever they might happen.
Our investment algorithm, ERAA®, closely monitors inflation and growth signals to determine the optimal asset allocation in any economic environment. This approach means that our portfolios are already prepared for the upcoming tapering, with exposure to inflation-hedging assets such as US Consumer Staples and Energy, REITs, Emerging Market bonds, and equity allocations to commodity-exporting countries like Australia.
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