The major forces driving the stock market just shifted dramatically. The devastating global pandemic created an economic crisis that sent shockwaves through the market in 2020. For a full year, investors carefully tracked COVID-19 recovery news with outbreaks and lockdowns representing the biggest risk in the eyes of most asset managers.
But that's all changed, according to a Bank of America survey, and you should make sure your stock portfolio is set up to handle the shifting landscape.
Stimulus and the stock market
Chatter about inflation and monetary policy has been bubbling under the surface for months, but those topics exploded into the spotlight over the past few weeks. The dire economic repercussions of a global pandemic triggered an unprecedented response from fiscal and monetary authorities to prop up businesses and consumers. The federal government sent checks directly to households, provided disaster loans to businesses of all sizes, and created targeted grants for employers. These were all designed to support consumer spending and to keep people employed.
Meanwhile, the Federal Reserve increased the supply of cash in the economy and pushed interest rates down. This provided financing and liquidity for businesses, keeping people employed. Low interest rates also stimulate the housing market and purchases of big-ticket items such as automobiles. Most economists agree that these measures were necessary to avoid catastrophic consequences, but there is always disagreement about the best way to manage and unwind these policies as the economy recovers.
To instill confidence, the Federal Reserve has repeatedly established a long timeline for rates to remain low, setting expectations that businesses would be supported until 2023 or 2024. If the economy is strong enough on its own, then low interest rates generate rapid growth. It also encourages more capital to flow into the stock market -- bond yields are less attractive, and the promise of strong corporate results also encourages investors. The expectation of sustained low rates, therefore, drives stock prices higher.
A new threat emerges
Early in 2021, economic indicators and corporate earnings suggested the recovery might be coming along quicker than expected. The economy was reopening with pent-up demand, and consumers were buoyed by stimulus checks in their bank accounts and by massive increases in the value of their homes and stock portfolios.
This kicked off a series of events that could easily lead to rapid inflation. Supply chains that were shut down or disrupted last year haven't fully recovered, creating a relative scarcity in availability for a multitude of goods and services in the economy. Meanwhile, consumers are showing a willingness to pay higher prices in many cases. Employers are also increasing wages to rapidly restaff as some businesses resume normal activities. These factors are all pushing prices higher across the economy.
That's not an enormous problem on its own, assuming that rising consumer prices are relatively modest. However, the Fed is mandated with balancing unemployment and inflation. If employment comes roaring back and drives consumer prices uncomfortably high, the central bank will be forced to abandon its low-rate timeline. Higher interest rates will almost certainly exert downward pressure on stock prices -- capital will flow to lower-risk assets if they can deliver better returns than we're seeing today. That's exactly why asset managers have turned their focus to inflation indicators and the bond market.
How to manage risk in today's market
Unfortunately, this is a complicated market for investors to navigate. Trying to time all of these moves is nearly impossible. You'd have to correctly predict unemployment and inflation trends, then correctly predict the timing of the central bank reaction. Meanwhile, you would also need a firm grasp on the dynamics of a global disease that mutates periodically while dissipating in some nations and simultaneously ravaging others. That's a tough proposition.
We're seeing these complications play out in real time in the stock market. Volatility has leapt upward in recent weeks, while different sectors surge and tumble from day to day. Value stocks have outpaced last year's growth stock darlings, but the tech sector still turns in huge gains on some days. We even saw stocks rise following a disappointing employment report, because investors became less worried about Fed tightening.
Most investors can win in the current risk environment by taking a long-term approach, developing a plan, and sticking to it. Diversification can also be helpful to avoid the biggest pitfalls from concentration in a group of stocks that might get slammed. Growth stocks are being beaten up right now, but their fundamental outlook over the next decade or two hasn't really changed, so don't be scared to keep some growth in your portfolio. If you didn't have any value stocks in your portfolio, it's not too late to add some for balance that will provide upside regardless of how the next few months shake out. If you aren't ready to withstand some short-term volatility, consider adding some bonds and dividend stocks to your allocation to smooth things out.
At all costs, avoid reacting emotionally to scary headlines or confusing market conditions.
This article originally appeared on The Motley Fool.
