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Fed Policy Fuels Volatility, but Other Forces Are Along for the Ride

Financial markets may be in for more bumps in the road as investors seek near-term clarity from ongoing uncertainties.

Cars in traffic.

  • From rising inflation to waning Federal Reserve (Fed) support to geopolitical unrest, market volatility remains heightened and is likely to persist.

  • Against the uneasiness, economic and labor market data remain robust.

  • In uncertain times such as these, it’s important to avoid knee-jerk investment decisions and focus on normal market dynamics and time-tested investment principles.

  • Despite the macro-environment, company earnings remain the driving force for stock performance.

  • Bond sectors less sensitive to rising interest rates may offer opportunities for fixed-income investors.

Fed’s Balancing Act Keeps Investors on Edge

Since late last year, fears of a Fed policy mishap have remained among the markets’ most pressing concerns. Specifically, investors worry about the Fed’s ability to temper escalating inflation without hampering the growing economy. Some fear the Fed has been too slow to act.

Consumer headline inflation soared through 2021, ending the year at a 40-year high of 7%. The Producer Price Index ended 2021 at a record-high 9.7%.1 And in the fourth quarter of 2021, the economy grew 6.9% (year over year), much faster than consensus expectations.2

As inflation surged, the central bank held rates steady at near 0%. For most of 2021, the Fed’s supportive stance hinged on the belief that inflation was transitory. But at their January monetary policy meeting, Fed policymakers admitted inflation is higher and more persistent than they initially expected.

Given this backdrop and the Fed’s generally positive view of the labor market and economy, rate hikes appear imminent. The stage is set for a rate-hike campaign to likely begin in March when the Fed concludes its asset purchase program.

With inflation at multidecade highs, some investors fear the Fed will launch an aggressive rate-hike strategy. And if rates rise significantly, they also worry the economy and corporate earnings may suffer.

Beyond the Fed, Markets Are Monitoring Many Influences

After extended periods of strong performance, investors may lose sight of ordinary market dynamics. Price swings and occasional corrections are normal functions of financial markets.

While the Fed’s tightrope walk may be the most significant factor fueling recent market unrest, it isn’t the only influence. Other issues contributing to market volatility include:

  • Rising interest rates. Interest rates have edged higher ahead of Fed policy tightening. Specifically, rising inflation and expectations for Fed tightening have pushed Treasury yields to their highest levels since late 2019. Higher rates mean higher borrowing costs, which, along with rising inflation, threaten corporate profit margins.

  • Lingering supply chain issues. Supply chain disruptions are affecting everything from computer chips to chicken wings. Amid empty store shelves, logjammed ports and trucker shortages, prices are soaring. And there’s little indication broad supply/demand imbalances will unwind any time soon.

  • The tenacious pandemic. Although some data suggest the omicron variant’s effects are fading, the pandemic continues to create headwinds. The virus’s latest surge has contributed to labor market shortages that, in turn, have aggravated global supply chains. But as virus case counts appear to be declining, some epidemiologists believe a COVID lull may be forthcoming. However, whether the lull lasts, or other variants take hold is anyone’s guess right now.

  • Geopolitical tensions. Concerns about U.S. and European involvement in the escalating conflict between Russia and Ukraine have triggered bouts of volatility. With Russia threatening to invade Ukraine, the consequences for Europe are at the forefront. Russia supplies nearly one-third of Europe’s natural gas and crude oil, most of which moves through Ukraine. Additionally, China’s aggression toward Taiwan and ongoing unrest with Iran remain potential sources of market turbulence.

Earnings Remain Key to Stocks

While economic and other factors are grabbing headlines, we believe corporate earnings will strongly influence the stock market’s direction in 2022. Supply chain bottlenecks and labor shortages pose risks to corporate profitability in the near term.

As companies issue their 2022 outlooks, we’ll look to corporate management views on these pressures. Are they decreasing? Or will management take steps to mitigate pricing pressures through price increases and productivity measures?

Despite the Fed’s hawkish pivot, we believe monetary policy will remain accommodative by historical standards, and several new growth drivers will resume. These include:

  • Enterprise digital transformation.

  • Factory automation and worker safety.

  • Remote-hybrid work models.

  • Digital payments.

  • New drug discovery.

  • Medical device innovation.

  • Electric vehicles.

Meanwhile, higher rates tend to benefit traditional value-oriented stocks, such as banks. Higher rates typically accompany improving economic activity, which leads to more loans. Higher rates also increase the appeal of dividend-paying securities, such as utilities stocks and real estate investment trusts.

Inflation, Rising Rates Drive Bond Strategy

Record government spending, a growing economy, Fed policy and elevated inflation should continue to push Treasury yields higher. In this environment, rate-sensitive bonds, including government securities and other high-quality bonds, face pressure. We generally favor shorter-duration bonds, which have less sensitivity to rising rates. We also believe credit-sensitive bonds offer better risk/reward potential in the current climate.

We expect annual headline inflation to peak in the first quarter of 2022. From there, it may moderate, but it likely will persist well above pre-pandemic levels.

Several trends, including record federal spending and deficits, rising wages and housing costs, supply/demand imbalances and corporate onshoring efforts, will continue to pressure prices. This outlook highlights our positive view of inflation-protected securities. (See How Bond Investors Can Combat Rising Interest Rates, Higher Inflation)

Control What You Can

Volatility comes with the territory for investors. That’s why it’s so important to think about the market’s daily movements in the context of your long-term goals.

You should also ensure your investment strategy aligns with your tolerance for market fluctuations. And if you’re uncomfortable with how your portfolio has reacted to recent volatility, it may make sense to talk to your advisor about your strategy.

No one can control volatility, but investors can make sure they’re adequately diversified to respond to market ups and downs.

Victor Zhang
Victor Zhang

Chief Investment Officer

Senior Vice President

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Read our latest articles and market perspectives.

“Consumer Price Index News Release and Producer Price Index News Release Summaries,” U.S. Bureau of Labor Statistics, January 12 and 13, 2022.

“Gross Domestic Product, Fourth Quarter and Year 2021 (Advance Estimate),” U.S. Bureau of Economic Analysis, January 27, 2022. 

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.

Diversification does not assure a profit nor does it protect against loss of principal.

Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.