The real danger comes from [the Fed] encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. (Paul Volcker)

Let’s just say it…2021 was a great year for the stock market!  Global equities returned 18.5%; the S&P 500 Index averaged a new high every 3.5 trading days; and drawdowns were modest and infrequent.  Unfortunately, it’s not always going to be this easy.  We must acknowledge that the market’s sharp and consistent rise was largely attributable to extraordinary monetary and fiscal stimulus designed to sustain the economy throughout the pandemic.  While the stimulus proved essential in avoiding recession and promoting the fastest recovery in US history, its impact could morph from beneficial to harmful as life returns to normal.  The highest consumer price inflation reading since the 1980s (6.8%) and speculative excesses in various markets are just two examples of the potentially detrimental effects that ongoing stimulus could have.

The Fed recognizes these risks, as evidenced by minutes of their December 2021 meeting, which were released on January 5^th.  Those minutes conveyed the need for policy adjustment more intensely and urgently than prior releases, particularly because inflation has proven to be more persistent and widespread than anticipated.  However, there’s a big difference between recognizing the risks and actually navigating a path between being too aggressive (which could lead to an economic slowdown and pullback in the capital markets) and being too accommodative (which could lead to higher inflation).  The Fed itself may not even know the answers to some basic questions such as: Is today’s inflation the result of supply chain issues or its own monetary policy?  How has the size and structure of the work force been changed by the pandemic?  How large should the Fed’s balance sheet be as things return to “normal”?  What real interest rate is consistent with full employment especially when facing the massive investments needed to address climate change?

Perhaps all that can be said is that investors need to prepare for a new era of monetary policy in which surfing the wave of liquidity is unlikely to be the optimal strategy.  Given that markets are likely to be more volatile in response to changing Fed policies, one should consider maintaining some dry powder in case periodic over-reactions present attractive entry points.  Within equities, value-oriented and cyclical issues (including international stocks) trade at substantial valuation discounts to growth stocks and could offer attractive relative returns.  However, no matter what happens, one shouldn’t expect a repeat of 2021 for some time.

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