After nearly two years of minimal volatility and steadily rising values, the stock market finally delivered its first correction during the first quarter of 2022. The standard definition of a market correction is a decline of 10% or greater from the market’s most recent high. At the start of the quarter, the market’s initial downturn was attributed to high inflation and the Fed’s hawkish tone on raising rates to combat it. Just as the markets started to digest the outlook for higher rates in the months ahead, the Russian invasion of Ukraine in late February brought about a second wave of volatility, challenging even the steadiest investors. After experiencing its worst January decline since 2009, the S&P 500 hit correction territory in February. After several more drops, equity markets began to rally toward the end of the quarter. In March, the U.S. equity markets recovered a few percent. Even with this recovery in prices, equity markets still ended the quarter lower with a mid-single digit loss. Normally this type of volatility in equity prices tends to favor bond prices as investors seek the safety of fixed income investments. However, the reaction was different this time as inflationary concerns and the Fed’s commitment to raising rates caused bond prices to fall slightly further than stocks for the quarter. All eyes were on the Federal Reserve and interest rates as the Federal Open Market Committee (FOMC) met in March and raised rates for the first time since 2018. This move set the tone for anticipating several more rate hikes in 2022 and 2023. In March, inflation rose 8.5% from 12 months earlier to a 40-year high. During this month, consumers experienced an average 24% increase in fuel prices from February, translating to nearly a 53% increase over the past year.
The conflict in Ukraine has added to inflation pressures both domestically and abroad as the onset of sanctions has further complicated the recovery of global supply chains. Whether it is at the gas pump or the grocery store, consumers are feeling squeezed and are looking for ways to reduce costs in their daily lives. Rising interest rates, inflation, and the war in Eastern Europe will continue to take center stage in the months ahead. There are still many other factors that will shape the landscape for investors, and we expect volatility to persist for the remainder of the year. However, if the equity and fixed income markets can overcome these risks, we could see a further recovery in asset prices.
FED & INTEREST RATES
On March 16, the Federal Reserve voted 8-1 to lift their key interest rate by 0.25% for the first time since 2018 to a target range of 0.25% to 0.50%. “The American economy is very strong and well positioned to handle tighter monetary policy,” Fed Chair, Jerome Powell told a press conference following the FOMC’s decision. “I saw a committee that is acutely aware of the need to return the economy to price stability.”
With inflation being a crucial issue for the Fed over the past few quarters, the decision for an initial interest rate hike did not come as a surprise to most analysts. The Fed’s internal polling or Dot Plot indicated that officials are prepared to raise rates 5-6 more times this year, which would put the Fed funds rate near 2% by year end. Additionally, the Fed stated that it would allow its $8.9 trillion balance sheet of treasury and mortgage-backed bonds to shrink by $90 billion a month starting at the next meeting. Both actions put upward pressure on interest rates during the quarter. With the Russian-Ukrainian conflict adding to the fragility of the global economy, markets were looking for the Fed to cite geopolitical risks as potential reason to adjust their hawkish polices on rates if warranted. However, the Fed has been reluctant to telegraph this stance as the war has substantially added to inflation pressures over the past two months. This has been viewed as an admission by the Fed that they are indeed behind the curve in addressing inflation.
GLOBAL ECONOMY & MARKETS
Inflation was the primary concern for world economies during the first quarter. The conflict in Ukraine has broadly exacerbated supply constraints in energy, agricultural, and materials related commodities putting further pressure on already historically high inflation figures. Oil and natural gas prices increased by nearly 39% and 51% respectively for the quarter. Both wheat and corn prices rose almost 30% on the prospects of lower production out of Ukraine and Russia and tighter global supply. Nickel, which is used in many industrial applications and battery production saw prices spike almost 130% in mid-March before settling up 53% at month’s end. Although the U.S. imposed heavy sanctions on the Russian economy in response to their incursion in Ukraine, much of Europe and the rest of the emerging market economies have been reluctant to impose sanctions that are as far reaching. We will be keeping a watchful eye on this conflict as well as the path of further Russian sanctions and the impact that this will have on world inflation.
U.S. consumer inflation increased by 8.5% from the prior year in March while producer inflation rose by over 15% for the same period. Economic growth is expected to slow for the quarter given the inflationary pressures at hand. As measured by the Atlanta GDP Now forecast, U.S. GDP is expected to grow at an annualized rate of just over 1% for the quarter. Cost pressures have started to reduce domestic personal consumption and the strength of the U.S. dollar is expected to curb net exports. Despite these headwinds, we still believe that the U.S. economy remains the most resilient compared to our global counterparts. U.S. 30-year mortgage rates rose by almost 1.5% during the quarter to nearly 5% as a result of the Fed’s action. This is a level that now surpasses 2018 highs. The drastic rise in mortgage rates has caused a noticeable slowdown in the housing market with existing home sales falling 7.7% in February from the prior month. With housing affordability and supply at multi-decade lows, this should cause housing prices to cool down in the months ahead.
Global equities were down over 10% in mid-March as the war in Ukraine unfolded. Equity returns managed to recover about half of their losses to close the quarter noticeably in negative territory. U.S. stock valuations were challenged during the quarter as inflation pressures weighed on profit margins. In a March survey of CEOs conducted by FactSet Research, the top concern raised by S&P 500 CEOs was the continued trend of profit margin declines in the quarters ahead due to higher input costs. Valuations not only reflected this sentiment, but the rising rate environment also contributed to a repricing of equities. At the start of the quarter, the S&P 500 traded near 22 times next twelve months earnings, a level where most analysts consider the market to be fully valued. As the quarter concluded, this forward price-to-earnings metric dropped to just over 19 times earnings. Although this level is still above the 25-year average of 17x, the almost 15% discount on stock valuations at the quarter close drew in many equity buyers which lead to the slight recovery at the end of the quarter.
When dissecting the U.S. stock market for the first three months of the year, there was a large disparity in performance between value and growth sectors with value sectors leading by a wide margin. In times of higher inflation and consequently higher interest rates, the prospects for growth stocks tend to be more challenged than value stocks. This is because higher interest rates not only drive up the borrowing costs of companies that are focused on revenue growth, but it also affects the valuation models used by Wall Street to derive price targets. Hence, growth stocks tend to be more interest rate sensitive in a rapidly changing inflationary environment. Energy was the best performing sector for the quarter as commodities prices skyrocketed. However, with the threat of slower growth, the more defensive value-oriented sectors such as utilities, healthcare and consumer staples also outperformed the broad market. The sectors that detracted the most from the performance of the S&P 500 were the growth-oriented sectors of communication services, information technology, and consumer discretionary. The drawdown of these sectors has not only repriced them to more reasonable valuations but has also created some discounts not seen in years. This is certainly evident in the communication services sector that now trades at an earnings multiple level close to the 2020 pandemic lows. The international markets fared much worse than the U.S. for the quarter. International developed markets trailed U.S. returns by nearly 2%, whereas emerging markets underperformed by almost 3%. Although many analysts in prior quarters have noted the relatively cheaper valuations in European and Asian equities, analysts are now becoming more critical of this view given the geopolitical conflict with Russia and the diminished prospects for growth in these regions.
Bonds and interest rates tend to move in the opposite direction. When interest rates rise, existing bond prices tend to fall and conversely, when interest rates decline, existing bond prices tend to rise. Recent times have not been very rewarding for bondholders. Bonds are often considered to be more stable than equities for investors. The volatility in the bond market this quarter was high and U.S. bonds had their worst quarter in 40 years. The Bloomberg U.S. Aggregate Bond Index, which includes mostly U.S. treasuries, underperformed the broad U.S. stock market slightly, posting its biggest quarterly loss since 1980. Short-term and intermediate-term bonds also experienced rate increases this quarter. The 10-year U.S. treasury yield finished the quarter at 2.35%, a significant jump from January's 1.5% starting yield. With rates expected to rise further this year to fight inflation, bond investors may continue to be challenged give the current environment.
However, it is important to note that although rising rates have created some price declines for bond investors, they have provided something that bond investors have been deprived of for quite some time, higher yields. When looking at bond yields across the world at the end of March, the U.S. offered the most attractive yields with the U.S. broad bond market yielding close to 3%. Excluding U.S. treasuries, almost every other major bond sector in the U.S. market ended the quarter with yields at and in some cases well above 3%. This is quite a change from the sub-2% yields that bond investors experienced over the past two years. Remember, bonds are typically viewed as a key component to a diversified portfolio and can provide a good shield from equity volatility. Even though rising rates may create a lackluster environment for bonds to generate stable returns in the near term, it is important to consider the key components of return behind bonds. Price appreciation/depreciation is just one aspect of a bond portfolio’s return and accounts for just 20% of total returns. However, the interest income and reinvestment of that income is responsible for approximately 80% of the return contribution to bond investors. So, although pricing pressures has detracted from performance for the start of the year, the starting yield at the end of the quarter will help compensate investors going forward. Nevertheless, bond investors should not be dismissive of interest rate policies, and we continue to diligently monitor how the Fed’s movement and rising interest rates affect bond yields.
As we enter the second quarter of 2022, inflation, rising rates, the Fed’s future policy response and Russia’s war on Ukraine will collectively be on the forefront of risks to watch. Additionally, Covid-19 variants as well as the mid-term election season could contribute to more volatility in the quarters ahead. Interest rate changes are far from done and the Fed is expecting several more increases this year and in 2023.Combined with a lower unemployment rate and better supply chain movement, the Fed is hopeful that the increase in rates will be enough to combat inflation. Fed officials estimate that barring any additional shocks to the economy, energy prices and supply chains are expected to normalize by the end of the year. This could very well drop the rate of inflation to 2.5% by year-end. During the initial liftoff of interest rates, the stock market tends to fall as markets reprice the path of higher rates. But after the initial adjustment, markets have historically risen during most rate hike cycles. This is because interest rates typically rise if economic conditions are improving. According to a Truist Bank study of the past 12 rate hike cycles, the S&P 500 posted a total return average of 9.4% with 11 of the 12 periods having positive returns. (Source: www.reuters.com)
Although it is difficult to predict exactly how equity markets will react to this interest rate hike cycle, many equity analysts believe that markets may have priced in most of the Fed’s rate path and that any improvement to geopolitical or economic conditions could be a catalyst to send markets back into positive territory. If inflation can return to the Fed’s target level of 2.5% in the second half of the year, this could indicate that bond yield increases may have already priced in most of the Fed’s interest rate policy for the year. According to Guggenheim CIO, Scott Minerd, “with intermediate bond yields above the Fed’s long-term inflation goal, investors may now enjoy positive real yields in bonds for the first time in many years if that target is reached later in the year.” This could also indicate that bond yields may have topped out for the time being. With information changing the economic environment on what seems to be a daily basis, it is important that we maintain a disciplined approach to investing in times of volatility. Although much of the news that hits the financial press may induce volatility in the short run, the majority of news events will pan out to be noise that can distract investors from their long-term goals and objectives.
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