Arguably the most important development in financial markets occurred this month with newly re-appointed US Federal Reserve chair Jerome Powell announcing the acceleration of the removal of monetary stimulus. This means short-term interest rates in the world’s biggest market are going to rise sooner than expected. We expect them to rise in 2022 in both the US and Australia.

In November the Federal Open Market Committee announced a US$15bn “taper” of the US$120bn a month bond-purchasing programme, meaning the Fed Reserve would cease increasing its balance sheet from mid-June. This will now happen months earlier, which means official interest rates should increase three times next year.

Read more about Investing in Small Caps. Why we picked these ASX Small Cap gems and their outstanding performance.

What does this mean for share investors? What shares should you buy now?

We wouldn’t buy stocks whose valuations are not based on firm fundamentals.

You need to buy/own stocks that are making sustainable profits with strong balance sheets (not too much debt and with cash reserves) positive cash flow and possibly paying dividends.

Stocks underpinned by strong fundamentals are companies that can withstand shocks. If they fall, you buy more.

They also represent the quality stocks that we favour in our Blue Chip Portfolio as well as those we recommend in our Small Caps publication.

Our advice throughout Covid-19, kicking off in the depths of the market in early 2020, was to buy quality stocks in small parcels. This advice has delivered strong profits and it still stands.

Why are interest rates rising?

Inflation, and jobs. The US Consumer Price Index (CPI) is increasing at a rate of 5% a year. CPI is the price level, while inflation is the rate of change in prices. The big deal is that the Fed is changing its description of inflation, by dropping the term “transitory”. Rather than trying to disentangle the permanent from the transitory (or temporary) components of inflation, from now on Powell indicated he would simply talk about increasing inflation.

Underpinning this is concern about ongoing evidence of supply shortages and increasing wages (truck drivers come to mind; there simply aren’t enough of them). These were Covid related but are now considered structural.

Put simply, Powell is concerned that the increase in inflation over the past 12 months is not transitory, and that without action to reduce the money supply (tightening), at the very least inflation will stay at 5%, if not move higher. Bear in mind that the Fed’s target is 2%.

Why is containing inflation important? Because if it does remain high you get the risk of stagflation – high and rising inflation associated with high and rising unemployment. Unemployment is what drives central bank policy; inflation is guilty by association.

The government wants people to have jobs. Economies need to grow so that those people (who are the economy) can pay taxes and their debts. This means the people in government keep their jobs.

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