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By Gertrude Chavez-Dreyfuss and Saqib Iqbal Ahmed
NEW YORK (Reuters) - The Fed's well-telegraphed taper announcement has done little to soothe the nerves of some investors, who remain on edge about stubbornly persistent inflation and are looking to trim risk as they prepare for rockier times.
The Federal Reserve on Wednesday said it will begin paring its monthly bond purchases this month with plans to end them in 2022, marking the beginning of less accommodative, or tighter, policy. But it stuck to its long-held view that high inflation would prove "transitory" and likely not require a fast rise in interest rates, prompting investors to call it a "dovish taper."
Rate hikes are still not imminent, as the Fed signaled it would stay patient - and wait for more job growth - before hiking.
Market reaction immediately after the announcement was muted, with the dollar falling while U.S. stocks gained. Investors, however, said that may not be sustained long-term.
(GRAPHIC: Breakeven inflation rates - https://fingfx.thomsonreuters.com/gfx/mkt/dwpkregodvm/Pasted%20image%201635981069299.png)
"As inflation persists in a very strong way... people will become a little more nervous. That's when you'll see investors maybe dialing back on their risk exposures," said Lon Erickson, portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico, adding that this could set in during the first half of 2022.
Erickson favors shorter-duration assets in the fixed income space to protect from looming volatility as inflation continues to surge.
The central bank's easy money policies have been a source of significant support for financial markets, with the S&P 500 more than doubling since its March 2020 low during the onset of the pandemic. However, that has raised concerns about stretched valuations and a piling into comparatively risky assets, such as stocks.
"It's a dangerous game when financial conditions are this loose, the economy is doing this well and inflationary pressures are this high, to be running monetary policy for a crisis-like environment," said Troy Gayeski, chief market strategist for FS Investments. He advises investors seek products with inflation protection and avoid investments like long-duration U.S. Treasuries, whose value erodes with inflation. "But it could be setting us up for a really tough 2022."
Globally, central banks have flagged tightening, with the Bank of Canada giving hawkish signals about its outlook and the Reserve Bank of Australia suggesting interest rate increases are on the way. The Bank of England, though, surprised markets by keeping rates on hold.
Chris Zaccarelli, chief investment officer at Independent Advisor Alliance in Charlotte, North Carolina, said that given the uncertainty on inflation and interest rates over the next 12 months, he believes it prudent to maintain equity exposure, but reallocate portfolios toward companies with strong balance sheets and robust pricing power and away from those that are more speculative in nature.
Cliff Hodge, chief investment officer at Cornerstone Wealth, said in a "dovish taper" environment, he's looking at lower volatility and higher-quality assets.
Todd Sandoz, co-head of global equities at Barclays, said that for equity markets, the key question will be how earnings growth balances against increases in nominal rates.
"Where equities would really underperform is if inflation expectations and nominal rate increases... dramatically outpace earnings growth. That's where you get a very bad scenario for equities."
The benchmark 10-year yield was at 1.56% on Thursday, below recent peaks of 1.7% in late October, while the 2-year yield, which is sensitive to interest rate expectations, fell to 0.4%.
The Treasury market has churned in recent weeks as investors sharply increased expectations that inflation would force the Fed to raise rates sooner and more quickly than projected. Short-term rates have risen and the yield curve flattened, before partially receding.
Investors, however, have generally praised the Fed for well-telegraphing the taper. That is in contrast to 2013, when bond yields rocketed during the so-called "taper tantrum" after then-Fed chief Ben Bernanke unexpectedly told lawmakers the central bank could slow its pace of asset purchases that had been propping up markets.
Futures on the federal funds rate, which track short-term rate expectations, were little moved on Thursday, continuing to price in two rate hikes next year.
Despite the pending tightening, some investors still see a positive investment environment.
Jack Ablin, chief investment officer at Cresset Wealth Advisors in Palm Beach, Florida, who is comfortable owning equities despite some reservations about lofty valuations, said Wednesday's meeting and Fed Chair Jerome Powell's comments were reassuring.
"I do think the economy is strong enough to withstand a tighter Fed," Ablin said.
(Reporting by Gertrude Chavez-Dreyfuss and Saqib Iqbal Ahmed; Additional reporting by Megan Davies; Editing by Sam Holmes and Dan Grebler)