4 Scenarios for the Fed’s Tapering: From Benign to Horrible

All we know is that the Federal Reserve will begin slowing its massive ($120 billion per month) bond buying campaign, likely by year-end. That’s all Fed Chair Jerome Powell let on in his speech last week to the conference at Jackson Hole, Wyoming. The Fed head gave no indication about howmuch and how fast he’ll taper the purchases of Treasury bonds and mortgage-backed securities (MBS).

So veteran researcher Jim Woods has sketched out four different scenarios—and what they might mean to the economy and various asset classes. He classified them as “the good, the bad, and the ugly,” plus one other involving no tapering. That characterization is an homage to the classic Clint Eastwood Western movie: Fittingly, three gunslingers were competing to find a hidden cache of gold. For Woods, the slower the Fed reduces quantitative easing (QE), the name for the bond buys, the better.

The S&P 500 and Nasdaq Composite are both sitting at record highs, up 20.4% and 18.8%, respectively, for the year. Part of that continued rally is relief that the Fed won’t shrink its fixed-income purchases as rapidly as many feared. At least, that’s how the market has read Powell’s remarks. But how the Fed actually plays the tapering is unknown.

To Woods, the possibilities break down this way:

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The Good Taper. Here, the Fed starts the process in December, at a pace of $5 billion to $10 billion per month. The likely market reaction: Risk on, so the stock rally continues.

“The market is still viewing the Delta variant and COVID-19 spike as a temporary influence, so if the Fed tapered more slowly in response to it, that would create an environment where the economic recovery resumes” as the virus surge peaks, Woods reasoned. He looks for the S&P 500 to reach 4,750 or higher next year. It’s at 4,524 now, so that’s a 5% hike, meaning a slower tempo than we’ve seen lately. Multiples may go up, led by cyclicals and growth stocks, as well as commodities.

Treasury yields would ascend, although not radically, as the Fed’s continued QE would still be strong next year. The 10-year yield would rise to 2% in the coming quarters, up from the current 1.3%. The dollar would drop some, to 92, down from the Dollar Index’s 92.5 as of Wednesday. With inflation elevated, “commodities would be the biggest winners,” especially gold and oil, he predicts.

The Bad Taper. Come December, the Fed trims its buying at a rate of $15 billion monthly, ending QE in mid-2022. High COVID-19 caseloads and some worries about economic growth could pinch investors’ spirits, amid the more rapid tapering. Still, the negative impact of this level of tapering is already mostly priced into markets. “As long as the market views the virus spike as temporary (and it still very much does) then this tapering schedule won’t derail the rally,” Woods wrote.

Stocks could slip modestly, he commented, but “I wouldn’t expect too big of a move.” Defensive and large-cap tech stocks would outperform cyclicals and value. Treasury yields should rise back into the upper 1.5% range, yet the increase in the 10-year yield wouldn’t be “disorderly.” The dollar shouldn’t move much, to 93, and commodities would inch up, too.

The Ugly Taper. The Fed begins tapering QE in December at a monthly rate of $30 billion, ending QE before June 2022. “This would be a shock to markets and substantially increase stagflation concerns,” Woods warned. Such a large cut would “clearly signal that the Fed is nervous about inflation regardless of the loss of growth.”

The likely market reaction would bepain. Stocks would drop sharply, led by cyclical sectors such as energy, materials, and consumer discretionary. The large techs, consumer staples, and some financials (helped by higher interest rates) would relatively outperform. Overall, however, the market would be “sharply lower.” Treasury yields would surge (the 10-year yield would head to 2%), and the dollar would glide up, as well, with its index at 95. “Commodities would be the biggest loser and gold would get hit very, very hard,” Woods said.

The Called-Off Taper. “Would a ‘No Taper’ be good for stocks?” Woods wondered. His answer: no, “at least not beyond the very short term.” Markets might believe a tapering delay would help stocks. But he says any market rise would be short-lived.

Reason: “sustainably high inflation is much, much bigger medium- and long-term risk to stocks than COVID-19 (as long as the vaccines hold the line).” Corporate margins would get squeezed. If this zero-tapering scenario transpired, “we’d be looking to get majorly defensive after that initial pop,” Woods warns. Qualms that un-tapered QE would lead to more inflation are serious. As Woods put it, “Keeping inflation under control is much more important for the long-term health of the bull market than anything else.”

Taper Timing: Will the Fed Move … in September? December? Next Year?

OK, When Will the Fed Begin Shrinking Its Bond Buying, Anyway?

Tags: Commodities, dollar, Federal Reserve, Jackson Hole, Jerome Powell, Jim Woods, mortgage-backed securities, Stocks, tapering, Treasury bonds

The US Chamber of Commerce has lashed out at the “handful of law firms” behind a recent surge in lawsuits that accuse fiduciaries of employer-sponsored retirement plans of breaching their fiduciary duties by failing to minimize fees or provide better-performing investments.

“No plan, regardless of size or type, is immune from this type of challenge,” the business organization and powerful lobbying group recently wrote in a submission to the US District Court for the District of Columbia. “Converting subpar allegations into settlements has proven a lucrative endeavor—mostly for the lawyers bringing these lawsuits, though, rather than the plan participants they purport to represent.”

The comments were made in a brief of amicus curae (i.e., a friend of the court brief) in support of the dismissal of an Employee Retirement Income Security Act (ERISA) lawsuit against the American Red Cross. The lawsuit, filed by members of the American Red Cross Savings Plan, accuses the plan’s fiduciaries of breaching their duties by failing to properly review the plan’s investment portfolio and control the recordkeeping costs. The plaintiffs allege that this cost the plan and its members millions of dollars.

“This case is one of many in a recent surge of class actions challenging the management of employer-sponsored retirement plans,” the chamber said in its brief. “What began as a steady increase has exploded in the past 18 months, culminating in over 100 excessive fee suits in 2020—a five-fold increase over the prior year—and many more lawsuits filed this year.”

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The Chamber of Commerce, which claims to be the world’s largest business federation, represents approximately 300,000 direct members and indirectly represents more than 3 million companies and professional organizations. Many of its members maintain or provide services to ERISA-governed retirement plans.

In its brief, the chamber said attorneys use the benefit of hindsight to “second-guess the decisions of plan fiduciaries” and identify a better-performing or less-expensive investment option or service provider than the ones chosen.

“The lawsuits typically follow a familiar playbook, often with cookie-cutter complaints,” said the brief. “Lawyers frequently find a plan sponsor to sue, advertise for current or former employees willing to serve as plaintiffs, and pursue the litigation, often with minimal communication with their clients during the process.”

The chamber also said just five law firms were responsible for the vast majority of 401(k) litigation in 2020, and it cited Capozzi Adler, which is the plaintiffs’ counsel in the Red Cross suit, for being behind nearly half of all recent ERSIA lawsuits. The law firm did not return a request for comment.

The chamber said the lawsuits often cite occasional periods of underperformance of certain funds or note that other lower-fee options were available among tens of thousands of options offered in the marketplace. It said that rather than allege that the plan fiduciaries used a flawed process in making their decisions, the lawyers ask courts to infer that plan sponsors must have breached their fiduciary duties because they didn’t choose the better-performing or lower fee investments for their plan’s lineup.

“It is always possible for plaintiffs’ attorneys to use the benefit of hindsight to identify, among the almost innumerable options available in the marketplace, a better-performing or less-expensive investment option or service provider than the ones chosen by plan fiduciaries,” said the brief.

The chamber also said the surge of litigation “has significant negative consequences for plan participants” in that it pressures fiduciaries to limit investments to a narrow range of options at the expense of providing diverse choices with a range of fees, fee structures, risk levels, and potential performance upsides. It also said the rise in litigation has led to “a cascade of changes” in the insurance marketplace that require plan sponsors to spend much more on liability insurance, which it said has also become more difficult to obtain.

“This increased cost—compounded by a significantly increased litigation risk—works to the detriment of employees seeking to save for retirement,” said the chamber, adding that it could mean less generous contributions from larger employers or that it could make sponsoring a retirement plan cost-prohibitive for smaller ones.

“In short, these suits will, if successful, simply inflate the costs of establishing and administering a plan,” the chamber said. “That is precisely what Congress sought to avoid in crafting ERISA.”