January brought both frosty weather and a frosty reception in the financial markets. Global stocks and bonds are experiencing declines, albeit of very different magnitudes across asset classes. Much of the recent turmoil has been attributed to the Federal Reserve’s focus on reigning in the easy monetary policy it adopted in response to the COVID-19 pandemic to support the economy.
What exactly is the Fed reigning in?
The Federal Reserve communicated last year that it would begin tapering its purchases of Treasury bonds and agency mortgage-backed securities, which helped provide liquidity to the economy and financial markets following the pandemic-induced 2020 recession.
It has since accelerated the timeline of that tapering.
Coming out of the December meeting, Fed Chairman Jerome Powell communicated that, with economic conditions improving and high inflation persisting longer than expected (December’s CPI reading was 7%1 — the highest in four decades), it would likely begin raising rates in 2022.
The biggest surprise from the December meeting was that the Fed is also starting to think about when it would begin reducing the size of its balance sheet. By comparison, it took much longer for the Fed to think about doing the same coming out of the 2008 financial crisis. This economic downturn and ensuing recovery have taken place at a lightening pace compared to 2008, not to mention how much greater the Fed balance sheet expansion has been this time around.
In the January meeting, aside from laying out high-level principles for balance sheet reduction and indicating that rate hikes would begin “soon,” there was not much additional new information.
Bad news: Greater volatility
While we have seen greater volatility these past few weeks, particularly leading up to the Federal Reserve January meeting, it’s difficult to pinpoint a single cause. Perhaps there is concern that the Fed may act too quickly to raise rates, thereby causing a recession; perhaps we had very strong returns the last two years and investor appetite for risk is lower in the new year; or maybe it is worries that Russia will invade Ukraine or that the omicron COVID-19 variant spread has tempered future growth expectations. It’s likely a combination of all these factors and more.
Good news: Current market volatility is normal
What we do know for certain is that the volatility we are currently experiencing is normal. If we look at data going back to 1979, the U.S. stock market on average has a drawdown of 14% at some point during the year. Keep in mind U.S. markets still end the year with a positive return in over 70% of the years.2 Additionally, market pullbacks in January are common and do not necessarily have predictive power for what the rest of the year is going to bring, as we can see from the chart below3:
More good news: A well-positioned portfolio can help
While it’s never easy to see the value of your portfolio decline, the positioning of that portfolio in the current environment can be beneficial relative to the broad indexes.
One of the consequences of rising rates is that cashflows that are further out in the future become less valuable to investors because you are using a higher interest rate to discount those future payment streams. As a result, we have seen growth stocks, stocks of companies that are unprofitable and long-duration bonds suffer the most in the current pullback. If the equity portion of a diverse portfolio has greater exposure to value stocks and profitable stocks, that has helped temper the declines.
Additionally, intermediate term bonds have also held up better than long-duration bonds with the expectation of rising rates.
The Ugly: Cryptocurrency, SPACs and meme stocks
In this recent bout of volatility, we have seen some areas of the market pummeled much worse than others. With a less easy monetary policy, speculative areas of the market like cryptocurrencies, SPACs (special purpose acquisition vehicles) and meme stocks have experienced huge declines.
These are parts of the market that we’ve avoided recommending because they lacked solid economic rationale for investment, or we viewed them as too risky. Interestingly, they were also some of the hottest investment trends in 2020 and 2021. We discussed back then why we were avoiding such stocks, which you can read about here.
They provide a great example of why it’s important to maintain discipline as an investor and not let a fear of missing out (FOMO) draw you into speculative assets or make them such a disproportionately large part of your overall portfolio that it can be detrimental to your long-term success.
Wrapping it up
Investors have experienced a rough start to the year, but there are many silver linings. A diverse portfolio is well-positioned to handle this current storm. What’s more, looking for opportunities to strategically rebalance your accounts (sell assets that have appreciated and buy into segments of the market that have dropped) and tax loss harvest (take paper losses that can be used to offset future taxable gains) can also help. This is the time to maintain discipline and not let fear of the current market gyrations or headlines steer you from your long-term course.
If you’re looking to diversify your portfolio and work with a firm that strategically rebalances your accounts and tax loss harvests, learn about Wipfli Financial Advisors.
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Markets climb despite uncertainty and volatility: reflections for fourth quarter 2021
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