The first quarter of 2022 felt eerily similar to the first quarter of 2020. We started both years with an optimistic outlook but were quickly sidetracked by an unforeseen event. The former being COVID-19 and the later being the Russia-Ukraine conflict. Concerns over the potential need for a faster pace of interest rate hikes to combat higher inflation also weighed on both equities and bonds. Major market indices all reached correction territory (down more than 10%) in early March, but subsequently recovered some of the losses going into quarter end.
Due to Russia’s role as a major energy and commodity producer, the heightened political tensions drove energy and commodity prices to extreme levels. This compounded the surge in inflation, supply chain disruption and the risk to global growth. Brent oil and natural gas prices spiked early in March before falling back, with prices up 33% and 55% respectively since the start of the year.
Developed market equities recouped some of their losses to end March up about 3% but were still down 5% year-to-date. Emerging markets declined a further 2% in March leaving them down nearly 7% year-to-date. Over the quarter, developed market value stocks were only down 0.5% while growth stocks fell nearly 10%. This was partly because 10-year Treasury yields reached 2.4%, up from only 1.5% at the start of the year. The Global Aggregate Bond Index fell 6.2% over the quarter, since bond prices move inversely to yields.
Throughout 2021, economists and the Fed believed that inflation was transitory due to pent up demand during COVID lockdowns. That began to change at the beginning of 2022. During the first quarter central banks became gradually more hawkish, driving bond yields higher. The war between Russia and Ukraine and the resulting commodity supply shock forced central banks to choose between taming inflation or supporting growth. Central banks have telegraphed that they view inflation as the more important problem unless growth begins to decline.
As a result, The Fed raised the target rate by 0.25%, and made it clear that further increases will be appropriate. The median voting member now expects seven hikes this year, and four next year. If that plays out, rates could end this hiking cycle higher than the committee’s perceived neutral rate of 2.4%. Additionally, the committee plans further monetary tightening by reducing the size of its now $9.0 trillion balance sheet, which could be announced “at a coming meeting”.
This is a familiar struggle for equity markets. On one hand we have an economy that is running very hot, with unemployment falling to pre-pandemic levels of 3.6% and continued strong consumer confidence which should support growing corporate profits. On the other hand, the Fed must get inflation under control and has a notorious track record of over tightening to the point of causing a recession. It is possible that the Fed engineers a “soft landing” for the economy with more normal growth while averting recession, but historically they rarely manage this feat. Currently the yield curve (difference between short term and long term yields) is inverted. This is an ominous occurrence that has predicted five of the past six recessions and tells us the bond market doesn’t believe the Fed can pull it off. That said, when the yield curve inverts, the economy does not typically enter a recession immediately. In most cases it takes 12 to 18 months before a contraction, and equity markets can continue to increase for a considerable period leading up to the recession.
In times of uncertainty like these, we find it best to keep it simple and focus on the fundamentals of our investing philosophy. We are long term investors, which means we are not going to make wholesale changes to the portfolios or move to cash and try to time the market. We are always looking for slight tilts in the portfolios where there is relative value across the asset classes. For the past year, we found that in “Value Stocks”. Then we found it by tilting towards international exposure (with a brief interruption by Mr. Putin). At this point in the Fed cycle we are evaluating moving away from the “Value” tilt and towards a “Defensive Growth” posture, which should outperform in a slowing economy. We maintain our tilt towards international assets due to the lower relative valuation compared to the U.S. We will also continue to watch the fixed income markets, but for the time being we do not feel traditional bond assets offer an appropriate inflation adjusted return.
As always, we appreciate your trust and are available at any time to discuss your specific portfolio and financial circumstances. Please reach out to our Wealth Advisor, Banner Clark, at bclark@sagacewealth.com if you have any questions.