Balancing opportunities and risks in today’s market

Market news | Updated October 27

Capital markets can be difficult to read as you try to determine how best to position your investment portfolio. The current environment seems to be no exception.

“Investors should pay attention to several key market considerations and policy issues as we close out 2021’s fourth quarter and look ahead to 2022,” says Eric Freedman, Chief Investment Officer for U.S. Bank Wealth and Institutional Asset Management.

From March 2020 to August 2021, the S&P 500, a benchmark for larger capitalization or “large cap” U.S. stocks, more than doubled in value. In subsequent weeks, the market moved in more of a trading range. At the same time, interest rates on U.S. Treasury bonds, which move in the opposite direction of bond prices, lingered near historic lows through much of the summer, but began to move higher again in September. What can investors expect going forward, and should they consider adjusting the mix of assets in their portfolios?

The economy’s direction clearly impacts market expectations. Unique challenges related to the global pandemic such as supply chain disruptions and worker shortages for some employers represent economic headwinds impacting market sentiment. Geopolitical events are another factor that have the potential to drive markets, at least in the short term. On top of that, legislative initiatives that could result in major new government spending programs and a range of new taxes are also on the table.

“While these are all potential issues that could come into play,” says Eric Freedman, chief investment officer for U.S. Bank Wealth and Institutional Asset Management, investors will want to closely watch four additional variables that may determine how capital markets trend from here.”

The key issues Freedman sees as having the biggest impact on the direction of stocks and other parts of the capital markets through the remainder of 2021 and into early 2022 are:

  1. Inflation, which emerged as an ongoing concern this year.
  2. Federal Reserve (Fed) policy, likely in for some adjustments based on economic developments.
  3. Consumer spending and how the pace of economic expansion from this point affects consumer sentiment in the U.S. and around the globe.
  4. Business capital spending, particularly in reaction to consumer attitudes.

Here’s a closer look at each of these issues.

Inflation – will the resurgence persist?

Inflation, a measure of changes in the cost-of-living, has been almost a non-factor for most of the past three decades. Beginning in May and continuing throughout September, the key measure of inflation, the Consumer Price Index (CPI) for All Urban Consumers, rose more than 5 percent over the previous 12-month period.1 The last time inflation reached levels that high was for a brief time in 2008.

“Even though we view the current inflation surge as transitory and something that will pass over time, it’s clear that the definition of transitory as it relates to inflation has lengthened,” says Freedman. “Markets have not given any indication that long-term inflation concerns have arrived, at least to this point.”

Price changes reflect the relationship between supply and demand. While demand in much of 2020 and early 2021 may have been supported in part by government stimulus checks in response to the economic fallout from COVID-19, current elevated CPI levels may be attributed to other factors. An imbalance between supply and demand drove prices higher in some segments of the economy, such as lumber and housing inventory.

“It’s less an issue of how high the inflation rate is now as much as whether it lingers after we rebalance supply and demand,” says Tom Hainlin, national investment strategist at U.S. Bank. Hainlin is watching corporate earnings reports for signs of how persistent inflation will prove to be. “If corporations see their profit margins affected by higher costs, that may raise some concerns,” he says.

Freedman anticipates that elevated inflation rates will subside by mid-2022, but risks are potentially skewed to a longer timeline should countries retain zero-COVID tolerance policies which could keep supply chains constrained. Over time, Freedman expects deflationary pressures to be more persistent than inflationary pressures, and attributes much of that to the realities of longer-term economic forces. “Demographic trends show an aging population and productivity is likely to decline,” says Freedman. These factors will likely keep growth rates more subdued as time goes on, and inflation is likely to follow a similar pattern.

Read more about inflation and its recent impact on investors.

Federal Reserve policy – is tapering upon us?

To this point, Federal Reserve chairman Jerome Powell has been clear in repeating that the Fed has no intention of raising the short-term interest rate it sets – the Fed Funds rate2 – prior to 2023. However, half of the members of the policy-making Federal Open Market Committee have indicated they anticipate a need for at least one interest rate hike in 2022. Inflation trends could be a factor. The Fed historically has used the strategy of raising interest rates to temper inflation.

Before doing that, however, the Fed appears ready to scale back another of its monetary easing strategies. Indications are that before the year is out, the Fed will begin tapering back its program of acting as a significant buyer in the bond market. Since early 2020, the Fed has been buying $80 billion per month in Treasury bonds and $40 billion per month in mortgage-backed securities. This added liquidity to these markets, propping up bond prices and keeping mortgage rates in check to support the housing market. The Fed is now poised to begin reducing the amount of bonds they purchase month-by-month, with the entire program likely to come to an end by mid-2022.

Freedman expects this action will impact the bond market. “If you have a buyer who is a source of demand for bonds, and then that buyer’s presence diminishes, the market has to adjust.” This might result in interest rates in the broader bond market rising at least modestly once the Fed acts, or prior to that as the market anticipates a tapering strategy. That said, how markets react to potential tapering of bond purchases by the Fed is an open question.

Freedman also points out that potential Fed actions also hang over the market. “A Fed policy mistake could create headwinds for stocks. If the Fed even signals that rate hikes might occur earlier or the hikes aggregate to higher levels than expected, investors might start moving money away from stocks and into bonds.” The Fed’s actions, as is usually the case, will be a major focus for investors.

Consumer spending – how long will confidence prevail?

Economic growth has been strong for more than a year, following a deep but relatively short-lived recession in the first half of 2020. As measured by Gross Domestic Product, the economy grew at annualized rates of 6.3 percent in the first quarter and a 6.7 percent in the second quarter.3 Consumer spending activity, as is typically the case, has been critical in fueling the recovery.

Consumer spending trends going forward depend on the level of new job creation, whether COVID hinders economic activity, and resolution of nagging supply chain issues that have led to shortages of some products. Government support will provide less fuel for the economy, with COVID relief checks no longer coming and the extended federal unemployment benefits program expired. Third quarter earnings reports that are being released may provide an indication on the strength that consumers are in a position to demonstrate.

“COVID-19 is still hanging over the heads of consumers as a risk,” notes Freedman, which might explain why many workers are reluctant to shift jobs at this time or even look for a job given low labor force participation rates. “Consumer sentiment has become a bit more subdued in recent months,” he notes, but the jury is out on what lies ahead.

Business spending – how does it hold up?

Business investment through capital expenditures tends to rise when ownership is confident that the global economy will sustain continued growth. Consumer attitudes play a big part in this. “Business spending is likely to shadow consumer spending,” says Freedman. This is a factor to monitor as a measure of how the global economy is performing and, as a result, what expectations should be for stock performance. Another factor worth watching is whether the business travel activity begins to approach levels that existed prior to the pandemic. To this point, it seems somewhat muted compared to pre-COVID times.

A new development for the global economy is the state of the business environment in China, the second largest economy in the world. Its leadership has recently tightened up regulations and exerted more control over specific industries and companies. Freedman notes that if the trend continues, it could have implications for business development in China and the ability of global companies to generate revenue from its burgeoning marketplace of consumers and businesses.

Learn more about China's impact on capital markets.

Implications for your portfolio

Shifting fiscal and monetary policies create the potential for a more volatile environment for capital markets. The possibility of policy errors at the legislative and central bank levels and prospect of persistently higher inflation represent risks that markets are currently digesting. As investors keep an eye on the issues discussed here, Freedman offers this overarching guidance for consideration:

  • Stocks should continue to be a prominent part of the portfolio mix, particularly large cap domestic stocks. “We retain a ‘half glass-full’ forward view, one that says the economy will perform well enough to benefit stocks and real assets over fixed income investments,” says Freedman. He believes the U.S. market is best positioned based on a more favorable economic outlook and the fact that some countries – like China – are undergoing structural and regulatory changes. While stock valuations are somewhat elevated relative to their own history, Freedman is confident that the most likely scenario is that earnings growth can meet expectations created by the recent strong run-up in stock prices.
  • Bond holdings should be pared back and adjusted. Bonds have enjoyed a 37-year run of solid total return and income while providing valuable diversification benefits for portfolios to help offset periods of stock market volatility. Freedman expects the bond market to face a more challenging environment over the next 5-7 years. “We believe non-agency mortgage bonds, reinsurance, bank loans and municipal bonds will provide the best opportunities for this segment of the market.” If inflationary pressures persist or even elevate, parts of the bond market could be vulnerable.
  • Real asset exposure can be an important way to round out a portfolio. This includes publicly traded real estate (such as REITs), private real estate, infrastructure investments, and potentially some commodities. “All of these categories should perform well if inflation remains elevated for a period of time,” says Freedman.

This is a good time to review your portfolio with your U.S. Bank wealth professional. Consider whether it makes sense to rebalance your asset mix. Given the significant rally in stocks, you’ll want to be certain that your current portfolio properly reflects your investment objectives and your risk tolerance level.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-capitalization stocks will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions.

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).

Diversification and asset allocation do not guarantee returns or protect against losses.

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