Positioning for a change from the Fed in 2021

While supportive monetary policy continues to be a positive for equity markets in the short term, the commencement of tapering will drive vastly divergent returns, at a rapid pace. Signals from the US Federal Reserve should be at the forefront of investors’ minds.

When the pandemic began gripping markets and economies in 2020, central banks around the world undertook asset purchasing at a scale and pace that eclipsed programs passed. In April 2020 alone, purchases by the four-largest central banks (the Fed, European Central Bank, Bank of Japan and Bank of England) totalled nearly USD1.5 trillion. This is approximately six times the amount purchased by these central banks at the height of the GFC. The Fed has never held a larger asset portfolio, with approximately USD7.8 trillion in assets, over USD3 trillion more than it held at the beginning of 2020.

With a roaring recovery at its heels in the US, and liquidity stabilising in markets, it logically follows that the Fed would soon consider a slowdown in its asset purchasing program. Economic forecasts suggest real GDP growth is expected to be greater than 5% in the US this year, close to the size of Australia’s whole economy.

An escalation in US consumer prices for April – which exceeded the consensus estimate and triggered falls on Wall Street and a spike in 10-year Treasury yields – is another sign of the magnitude of the US’s growth. This has been fuelled by both demand-pull and cost-push inflation, as government stimulus and consumers with pent-up spending are pulling price levels higher, while suppliers are needing to push through price increases as supply bottlenecks continue to ripple through the global economy.

Though the Fed might suggest inflationary pressure is transitionary, inflation is one by-product of growth, and the US economy is growing at pace.

The window we are eyeing for the Fed to begin tapering signalling is late June or August this year, the latter would coincide with the annual Jackson Hole conference. This view is supported by parts of the minutes from the Fed’s April meeting, suggesting officials are now considering when to start their discussions on winding back asset purchasing. There are two critical factors shaping our decision on timing of when financial conditions will tighten.

Jobs growth will move the Fed

First, and most importantly, is jobs data in the US. The Fed will need to be satisfied that the economy has self-sustaining growth before tapering begins, and Chair Jerome Powell has made it clear that jobs numbers are his critical indicator on productive capacity. He wants to see the labour market back to pre-pandemic levels, and disparities in the jobs market addressed.

In recent months, US jobs data has been on a strong upwards trajectory, despite some disappointments. April’s non-farm payroll employment rose by 266,000 which was significantly lower than forecast. Though April’s figures were low, they follow a strong boost in March, when 770,000 jobs were added and claims for unemployment benefits fell to their lowest levels during the pandemic. In February, 536,000 jobs were added.

Beneath the headline jobs miss in April, there were some positive developments. Labour force participation jumped for a second month in a row, suggesting workers are re-engaging in job search earlier than is typical in a recovery. The leisure and hospitality sector where low wage workers are most likely receiving a material degree of the federal benefit was the engine of job gains in April, adding 331,000 workers up from 206,000 in March.

Additionally, trends of the employed are often overlooked, which clearly makes up vast majority of the population. Average weekly hours jumped back up to the all-time highs experienced in January 2021, as employers turn to existing employees before gaining the confidence to make further hires. Finally, there are some logical factors which may explain the April dip such as seasonal adjustments, issues with the re-opening of schools and ongoing health concerns in some states.

Using history as a guide

Second, the move into tapering will be gradual, guided by lessons of the 2013 taper tantrum. When the Fed announced its plans to wind back its post-GFC asset purchase program, it came as a shock to investors, and triggered a panic in markets. The bonds market was most heavily impacted as investors moved quickly to sell, with Treasury yields jumping 50 basis points in the immediate aftermath. The Nasdaq fell 4%, and the MSCI Emerging Markets Index fell 14%. The Fed knows now that a long lead time, and cautious communication, is important in avoiding a shock to market expectations. This tells us we should have a nine-to-12 month window of signalling before monetary policy changes.

The Reserve Bank of Australia (RBA) will follow the Fed’s lead. Similar to the US, Australia’s economic recovery has surpassed expectations, though there are risk factors on the horizon, including the winding back of money growth in our largest trading partner, China. The RBA is equally fixated on “sustainable” employment levels, and figures for March released last month show an improvement on employment and hours work compared to March 2020, when the impacts of COVID-19 had just started to hit the Australian economy. Falls in the unemployment rate for March exceeded expectations, dropping to 5.6% from 5.8%.

Bracing for the inflection point

With these conditions ahead, we expect companies sensitive to the real economy will outperform, rather than those which have been inflated by monetary policy. There have been clear signs of this rotation since the last quarter of 2020, and it has continued into 2021.

For example, there was a rush on technology stocks in 2020, fuelled by prospects of growth as the developed world moved workforces, retail and socialising further online at rapid pace. In the last 12 months, there has also been a surge in tech IPOs in the US. However, tech stocks have tumbled in the reopening trade, as investors become wary of growth companies with less-certain earnings and lofty valuations. We expect companies without underlying profits – in tech and more broadly – will struggle to sustain their share prices in an environment where financial conditions are tighter.

We expect cyclical names to outperform over the next six-to-nine months, and have positioned our portfolio accordingly. We remain overweight in financials, and believe companies like the big banks are well placed to benefit from a market that is driven by real activity. Energy is another sector that is correlated with real GDP growth and it continues to outperform the broader market.

Generally, financial conditions tightening hits equity markets in aggregate. Positive equity returns will likely remain in Q2 and Q3, however we have less conviction on the outlook from Q4 onwards. And that is why, this year, we believe nothing will be more important for investors than what happens with monetary policy. Holding companies that will manage and advance through dramatically altered financial conditions will be critical for outperformance.