Luis Alvarado, investment strategy analyst for Wells Fargo Investment Institute:

Federal Reserve officials have signaled that they are one step closer to tapering their bond purchases program. They also can see continued progress being made towards their inflation and employment goals. Also, some officials revealed they have a growing inclination towards raising rates in 2022, while others still remain in the camp of not seeing rate hikes until 2023. Although the Fed has plans to begin tapering sometime by year-end and finishing bond purchases until the middle of next year, it is our belief that monetary policy will remain accommodative. We also do not expect to see an increase in the federal funds target rate in 2022.

We believe the latest summary of economic projections from the Fed officials indicate that the U.S. economy is still on track to display above average growth in the remainder of 2021 and well into 2022. We also expect supply chain disruptions and labor shortages to keep inflation elevated well into next year. This supports our view that in some sectors of the economy, inflation appears to be more sticky than transitory. For now, Fed officials appear to like how the U.S. economy is recovering, and this creates the opportunity for the Fed to announce an upcoming tapering on the November 3 meeting.

The initial reaction from fixed income investors after a tapering announcement may cause the yield curve to flatten slightly. However, after tapering is well underway, we expect yields to rise moderately. This will be a gradual, there will be a gradual decline in demand from the Fed while the economic recovery continues. And this will allow yields to rise to be more in line with fundamentals. A replay of 2013’s “taper tantrum” is unlikely, as the market seems to understand that tapering does not mean the Fed is ready to increase rates or to remove monetary stimulus immediately.

China’s economy has slowed this year, but we believe officials in Beijing have the capacity and the tools to aid in the recovery. A more immediate problem for the Chinese economy is the increase in regulation, which has seemed arbitrary and unpredictable. This pattern is set to continue, and there could be more pressures across different industries in China. In regards to the latest episode, involving China’s largest real estate developer, the contagion to global markets so far has been limited. There has been no surge of buying in perceived safe havens such as U.S. Treasury securities, the Japanese yen, or the U.S. dollar. And the reaction in Chinese equity and bond markets also seems narrowly focused on real estate and particularly on non-investment grade debt.

Our belief is that, up until this week, both the bond and the stock market had been relatively calm over the past few weeks. As a result of this, market participants appeared to be looking for the next catalyst that could break the narrow trading range in bonds and the cautious sentiment towards stocks. This week, the concerns arrived from a Chinese real estate development company. However, there are other series of events that could occur over the next three months that may insert volatility into financial markets. Our conviction remains that the global economy is in a recovery and expansion mode, led particularly by the U.S. We continue to favor, or have a strong preference, towards U.S. equities, particularly large-cap equities. For those investors that are more risk averse. We also continue to favor holding fixed income, but prefer a more defensive approach incorporating intermediate over longer term maturities.