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The Fed’s Changing Monetary Policy

Published on: Jun 30 2021

The markets are changing as investors anticipate and worry about the Federal Reserve’s plan to remove some of the liquidity it pumped into the economy since March 2020. Liquidity provided by the Fed has been the main influence on the economy and investment markets since 2009.

The Fed’s motivation has been to avoid a depression and deflation.The Fed began slowly weaning the economy and investors off its excess money creation in 2015, but then the Covid-19 pandemic hit. The Fed responded with a historic surge in liquidity, which was coupled with strong fiscal stimulus from Congress.

Now, with vaccines being widely administered and economic activity increasing, growth appears sustainable, and inflation is rising. The Fed already announced that it would take one small step to reduce liquidity by selling some of the corporate bond exchange-traded funds (ETFs) it bought in 2020.

While some argue that recent growth is fragile and the rise in inflation is temporary, both growth and inflation look sustainable.Many households improved their financial positions during the pandemic. That has carried through to strong growth in retail spending.Businesses now are straining to keep up with the higher demand.

They are planning to increase investment and expand production. Higher business investment will be another support for continued economic growth.Of course, if even a portion of the government spending proposed in Washington is enacted, that will sup-port additional growth.Risk and speculation worked well for both investors and businesses in 2020.

Zero interest rates coupled with fiscal and monetary support of the markets sent people into risky investments so they could earn positive real returns.

Stocks of companies that benefit from high levels of liquidity did very well in 2020. Leading the pack were stocks of companies with high profit margins, primarily technology companies. That’s because real interest rates (rates after inflation) were falling. Lower real interest rates cause investors to accept higher valuations for stocks of companies with high profit margins.

The major stock indexes, and especially growth stocks, rose faster than the economy and have done that for years.Changes in the markets began as real interest rates neared their lows. Stocks that generated the highest returns when real yields were falling started to struggle after real yields bottomed.

Stocks that struggled during 2020 are doing better in 2021 as real economic activity increases and the economy improves.Investments with high levels of speculation or that depend on liquidity are underperforming while real assets and companies that benefit from the real economy are doing better. Commodities and real estate are surging. Traditional value stocks are doing better than growth stocks.

I expect these new trends to continue as the Fed stops pushing high levels of liquidity into the economy and slowly withdraws liquidity.

The Fed isn’t going to act quickly or precipitously. Its actions will be deliberate and slow. But as investors anticipate changes in Fed policy, they will recalibrate prices for stocks and other investments.

Many aggressive stocks and other investments that soared in 2020 will struggle. So will investments that depend on liquidity or have low margins of safety. But other stocks and investments that benefit from economic growth will do well.

The fiscal and monetary policies also put downward pressure on the U.S. dollar. After recovering early in the pandemic, the dollar resumed a downward track. It now is at 12-month lows against most major currencies. I expect the steady decline in the dollar to continue.

As I’ve stressed for some time, inflation is likely to rise for a while. A basket of inflation hedges should be included in every portfolio.

Stocks outside the United States also will do well as the dollar loses value and economic growth increases out-side of America.In 2020, investors did best by taking risk, ignoring margins of safety, and focusing their portfolios on a few stocks and sectors.

As the Fed shifts toward new policies, it is more important to have margins of safety in your investments along with balance and diversification.

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