The first quarter of 2022 started out on rocky footing for financial markets. After declines in both global stocks and bonds for the month of January, Russia’s invasion of Ukraine in February exacerbated market concerns and led to further declines in equity prices for much of the rest of the quarter, before a 10%+ rebound during the second half of March. When all was said and done, the S&P 500 returned -4.6% for the quarter. Non-U.S. stocks fell 5.6%, with emerging markets stocks declining more than their developed market counterparts. In local currency terms, non-U.S. stocks declined less than U.S. stocks.
Interest rates increased substantially at all maturities during the quarter, causing bond prices to fall. The Bloomberg U.S. Aggregate Bond index lost 5.9% for the quarter. To provide context for the magnitude of the selloff in the bond market, this is the worst three-month period for the bond market since the three-months ended September 30, 1980. Prior to this quarter, there has only been one three-month period since 1985 where the bond market fell by even 4%. The bond market has not had two consecutive down years since the index was created, though it is hard to see at this point how that record will remain intact (clients may recall that the index was down 1.5% last year).
The world seems to be turning to monetary policy makers to alleviate elevated inflation. Just as was the case during the housing boom and bust prior to and during the Global Financial Crisis, low interest rates may have increased the magnitude of the eventual problem, but low interest rates were by no means the only cause of inflation. That said, increasing the federal funds rate seems to have been helpful in curtailing high home price inflation in the early 2000s and curtailing broader inflation in the early 1980s. Now that the labor market has strengthened, there is little reason for the Fed to not continue to tighten monetary policy. It is unclear how long the Fed will be able to continue hike interest rates and curtail economic activity before the next recession is underway. Market and economic data suggest that the probability of a recession over the next 12 months has increased since the beginning of 2022. We do not think this probability has increased to greater than 50%, but obviously this bears watching. Below we discuss some of the indicators we are watching in anticipation of such an economic slowdown.
The labor market continues to tighten and the unemployment rate has returned to levels last seen in December 2019. When data regarding job openings are added to the picture, it is reasonable to suggest that this is the tightest labor market we have seen in decades. Real manufacturing and trade industries sales are in an uptrend, as are industrial production and retail sales. These are positive for continued economic growth.
Real personal income has been very volatile since the beginning of the pandemic due to increases in government transfer payments. This measure is still higher than pre-pandemic levels, but it has been in a downtrend since August of 2021. Inflation, rather than wages, is the limiting factor here. If real personal income is to improve, it seems most likely that this will come from a decline in the inflation rate, rather than further increases in wages, as year over year growth of hourly earnings is at the highest level since the early 1980s. This underscores the importance of the Fed restricting monetary conditions in such a way that price increases are curtailed.
The conflict between Russia and Ukraine has led to incremental inflation that central banks would not have otherwise had to contend with. Our thoughts are with the people of Ukraine as they attempt to fend off an unprovoked invasion. While we do not yet know how the conflict will ultimately be resolved, we have already seen some of the negative implications for the global economy. The conflict is likely to further strain global supply chains amid the worst inflationary backdrop of the last several decades, which was already weighing heavily on the minds of consumers. This is yet another inflationary stimulus that has little to do with monetary policy, but at this point, higher interest rates seem to be one of the few widely accepted tools to curtail the associated inflation.
The situation in China also bears watching given China’s significant impact on global GDP as well as their role in global supply chains. COVID outbreaks have spread to several of the largest cities in the country and thus far they have maintained their stringent COVID zero policy which has resulted in significant portions of the country in prolonged lockdowns. We will likely see the effects of this policy in second quarter data, but it goes without saying that any incremental issues with global supply chains are problematic and a slowdown in China could spill over to the rest of the global economy. It does not seem likely that China will back down from their COVID zero policy at this point, but we could see significant stimulus by Chinese policymakers to offset some of the economic impacts of the policy.
As interest rates continued their climb higher throughout the quarter, spurred by both increases in growth expectations (earlier in the quarter) and increases in inflation expectations (later in the quarter), we began buying longer dated bonds in client fixed income portfolios. The income from lending out longer, and associated risk versus further increases in interest rates, made much more sense to us later in the quarter than at the beginning of the year. We were able to fund these purchases by selling short-term bonds that were held in anticipation of higher interest rates and were therefore down far less than the broad bond market. As equities become relatively less attractive as bond prices fall, these longer dated, high credit quality bonds are likely to provide greater diversification effects if the economy enters a recession and/or stocks enter a bear market.
On the equity side of things, we have not made major shifts. Although the end of 2021 gave us some pause with regard to our more value-oriented U.S. equity allocations, we held on and were ultimately rewarded with increased share prices that seem to have come from inflation concerns. These stocks generally still look relatively attractive on a valuation basis but are unlikely to have the same outsize earnings growth (recovery) they experienced last year. They also typically do not perform as well in economic recessions due to their more cyclical nature. Conversely, high-quality growth stocks, which now account for a substantial portion of the U.S. stock market indices, may be more resilient in an economic slowdown, but they still trade at elevated valuations that could be pressured by higher interest rates.
We would acknowledge that the euphoria of the economic recovery now seems to be well in the rearview mirror. We are now faced with heightened uncertainty amid a backdrop of global conflict, high levels of inflation, and an aggressive tightening of monetary policy. The risks perhaps remain elevated, but we would remind our clients that these factors are well known and likely reflected in asset prices already.
Markets go through cycles which often have similarities but also distinct differences. The best policy has been to stay invested throughout these cycles and take advantage of opportunities when they present themselves. Our portfolios remain well diversified – we have not been overweight stocks across client risk profiles since early 2021 and we’ve been adding to flight to safety assets such as longer-term bonds at much lower prices than where they began the year. We believe we are positioned reasonably across all risk profiles for a wide variety of potential outcomes and remain ready and willing to take advantage of opportunities when they present themselves.
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