Q1 2022 Market Perspective

Ask any economist or market analyst to recap the first quarter of 2022, and the response may include a wall of worries including the Russian invasion of Ukraine, surging inflation, the spike in interest rates, and a negative move in bond prices. Then ask what they expect for the rest of the year, and the focus tends to narrow considerably: “it all depends on the Fed.” We have many economic and market-related data points to digest and debate, and a few we’ll discuss in this note, yet there seems to be a consensus that the U.S. Federal Reserve Bank, or “the Fed,” is faced with a near-impossible task: to curb inflation without sending the economy into a recession. This does not impact our long-term view of the markets, but the growing list of worries reinforces our belief that market volatility will be a theme throughout 2022.


The U.S. stock market has proven to be resilient despite the volatility thus far. As we enter the second quarter, investors are wondering whether this recent recovery will continue higher, or if it was simply a relief rally within a broader market correction. Bond traders have been sending a more definitive statement though, as several traditional bond markets, like corporates and muni bonds, had their worst quarter in decades.


The Fed has been forthcoming with its plans to unwind its easy monetary policy, however the ripple effect of their decisions is largely unknown. It’s also possible they reverse course should the signals they rely on shift direction. From our standpoint, it’s impossible to predict how this plays out but economic data remains mostly favorable, especially as it relates to the consumer. We’ll soon also get valuable insight into how companies are navigating rising input costs, and whether those costs are being passed onto consumers, as we head into first quarter earnings season. Earnings results, and the commentary shared by management, often have a direct impact on near-term stock prices. That said, we emphasize that short-term market fluctuations should not cause us to deviate from a long-term strategy.




Q1 Market Highlights


  • Index returns [1]:

Major Asset Class Returns in Q1 2022

Source: 2022 Total Return as of 03/31/22, Bloomberg; See Chart A in Appendix


  • Globally, stocks declined during the first quarter. As referenced in the table, the large-cap segment of the U.S. market, was down 4.6% for the quarter. Followed by U.S. small-cap and mid-cap stocks, which were down 5.6% and 4.9%, respectively. International stocks also fell, with developed market stocks down 5.4% and emerging market stocks down 7%. [1]

  • Stocks declined early in 2022 as investors digested Fed commentary around interest rates hikes and the reduction of their balance sheet. All of which are policy tools designed to slow down the economy and curb inflation. As the stock market indices started showing signs of improvement, the crises in Ukraine escalated and volatility picked back up in late February into March. Once again, the market showed signs of resiliency and the S&P 500 total return index, for example, recovered considerably from being down roughly 12.5% at one point in the quarter.

  • There were no shortage of challenges for the fixed income markets during the first quarter of 2022. Most notably, the Fed has made a profound shift in its monetary policy from the goals stated during the final 3-4 months of 2021. The yield on 10-year Treasury bonds increased by 80 basis points during Q1 to 2.32% (as of 4/11 the rate has risen even higher to 2.77%). Bond prices, which move in the opposite direction of yields, fell and 10-year treasury bonds declined -6.9% during the quarter. Investment grade corporate bonds fell -7.7% while municipal bonds fell -6.2%. Investors had not seen negative returns like this on “safe haven” assets in decades.

Headline Themes for 2022

As we stated in our introduction, there are many current topics that are hotly debated, most of which will either impact or be impacted by policy decisions of the Fed.



Can the Fed Curb Inflation Without Sending Economy into Recession?

  • The annual inflation rate in the U.S. accelerated to 7.9% in February, the largest annual rise since the early 1980s. [2] High levels of inflation first appeared in 2021, driven by massive stimulus, post-lockdown reopening, robust consumer demand, soaring energy costs, and supply constraints. Currently, transportation, shelter, and food costs are driving inflation.

  • Inflation expectations had started to ease prior to Russia’s invasion of Ukraine, which drove up energy prices and exacerbated the strained supply/demand imbalances. It can be argued that inflation should ease naturally on its own in a post pandemic environment. Ports have reopened, manufacturing and supply has come back online and consumer demand has shifted from buying goods to spending on services like travel, dining, and entertainment.

  • However, we can’t rely on the hope that inflation eases on its own as inflation disproportionately impacts lower income families and households with fewer resources to cover rising costs of living, such as housing costs. Thus, the Fed needs to act.

  • This seems like an impossible task to get exactly correct, which is why we expect the Fed to act swiftly with their policy moves as they have laid out, yet be ready to quickly change their narrative.


Strength of the Economy and Consumer

  • Overall, the U.S. consumer continues to remain strong, however Consumer Sentiment (an economic indicator that measures how optimistic consumers feel about their finances and the state of the economy) is showing real signs of weakness. Driving the poor sentiment is concerns over the costs of real goods, i.e. gas, housing, food. The University of Michigan Consumer Sentiment reading in March was 59.4, the lowest reading since August 2011. Sentiment had steadily increased from a low of around 70 during height the of Covid in 2020 to almost 90 in April 2021. [3]

  • With that said, while consumers are concerned about prolonged inflation, how long must inflation persist before it materially impact spending habits? There are nearly 11 million job openings in the U.S. and the unemployment rate is currently 3.6% (back near pre-pandemic levels). [4] Consumers are employed and have opportunities to move jobs, during a time where wages and salaries are also increasing.

  • As a reminder, consumer spending accounts for more than two-thirds of GDP (a measure of U.S. economy growth). GDP expanded 5.7% in 2021, the strongest growth rate since 1984.[5] Economic growth will slow, by design, as a result of the Fed’s tightening of its monetary policies. Expanding on the difficulty of the Fed’s job, they must weigh the economic impacts of their policy decisions in real time, as to prevent going too far, too fast.


Yield Curve Inversion and Recession

  • Investors will often look at the spread between short-dated Treasury bonds and long-dated Treasury bonds as an indicator of economic strength or weakness. A steepening curve typically signals expectations of stronger economic activity, higher inflation, and higher interest rates. A flattening curve can mean the opposite: investors expect rate hikes in the near term and have lost confidence in the economy's growth outlook. Thus, an inversion of the curve (when short term rates have higher yields than longer term rates), has reliably predicted low future growth and indicates a high probability for an economic recession.

  • This stands to reason when you consider what happens when an economic expansion turns into an economic contraction (or recessions). The Fed is tightening its monetary policy stance by raising short-term interest rates, attempting to slow economic output. While recessions are normal, we are keeping a close eye on whether the Fed overshoots its “moving” targets.

  • Adding to the debate on the yield curve is that the Fed’s aggressive post-COVID policies, namely its bond buying program, has resulted in an undervalued 10-year Treasury yield which is more susceptible to an inversion with short term rates which the Fed has already started to increase. As of early April, when writing this note, we are starting to see the yield curve steepen in certain key areas.


Broad Stock Market and Individual Stock Price Valuations

  • The stock price of a company is closely tied to its projected earnings growth, as well as many other factors such as profitability, balance sheet strength and competitive positioning. In other words, stocks tend to be valued favorably when earnings are expanding. As it stands today, earnings expectations are increasing and corporate balance sheets are strong. While we would not expect companies to raise earnings guidance when Q1 earnings are released, we do know that analyst earnings estimates have increased for 2022 as well as 2023. This is a positive sign for stocks when you are positioned for the long-term.

  • Beneath the surface of the broad market lies significantly more volatility for individual stocks and market sectors. We have seen weekly leadership changes within sectors such as technology, healthcare and energy as well as heightened volatility in certain stocks, namely high growth companies. Meanwhile, and importantly, mega cap names such as Apple and Microsoft, sustained their market values despite the volatility this quarter.


Fixed Income Outlook

  • For the remainder of the year, performance in the fixed income markets will depend on the path of tightening that the Fed decides to follow. Each time they speak, we seem to hear a more hawkish tone with expectations we will now see a 50 basis point hike in May. In addition, the Fed has recently indicated that they will begin to shrink their balance sheet by unwinding some of the pandemic related bond purchases they had made over the past two years. The timing of this form of quantitative tightening has accelerated from recent expectations.

  • We continue to recommend certain fixed income investments within a diversified portfolio. While headwinds remain, the recent sell off in bonds has resulted in more attractive yields in different segments of the fixed income markets. We remain underweight duration and focused on higher credit quality issuers. We also see some value in investment grade corporate credits. Corporate credit spreads have performed surprisingly well given the recent volatility, which reflects the strong state of corporate balance sheets. With a flat yield curve, we are finding attractive yields in short and intermediate maturity high quality corporate bonds.



Summary


The Fed has a tough job to do this year, not only in the execution of policy decisions and in the narrative they provide, but also in attempting to assess real time economic data. We have stated in this note our belief that their job seems near impossible, but we expect that the Fed is willing to shift its policy as appropriate and therefore we are comfortable with the uncertainty this presents to the market.


Whether its inflation, GDP growth, the yield curve or Russia’s war, we have plenty of near-term risks to monitor and debate over the next few quarters. Yet it is a helpful reminder that as new concerns arise, uncertainty is an acceptable and commonplace risk and planning for market volatility is essential to the construction of a long-term investment strategy.


You have heard us say many times that ‘time in the market’ is more valuable to the success of your financial strategy over the long-term than attempting to ‘time’ the market. In other words, the existence of volatility or uncertainty should not cause any deviation from your strategy that is designed to withstand market cycle fluctuations based on your specific set of circumstances.


We look forward to speaking with you soon.



Gregory Slater, CFA, CFP®, CIPM®

Chief Investment Officer




Appendix


Chart A: 2022 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2022 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes


1 - Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index

2 - United States Consumer Price Index (CPI)

3 - United States Michigan Consumer Sentiment

4 - United States Unemployment Rate

5 - United States GDP Growth Rate

 

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