Investment Management Newsletter - 1st Quarter 2022
A Quarter to Forget
The first quarter served up a quadruple whammy: Omicron, Russia’s invasion of Ukraine, persistently high inflation, and increasing interest rates. Omicron hit the U.S. hard in January, but fortunately receded quickly only to be replaced by concerns over Russia’s invasion of Ukraine in late February. Meanwhile, high inflation, which the Federal Reserve had initially characterized as “transitory,” proved to be rather sticky, reaching a 40-year high of 7.9% in February (CPI). The war in Ukraine fueled further price increases that were already at record levels due to labor and supply chain constraints. Then, the Fed increased the federal funds rate for the first time since 2018. There were few places to hide during the quarter as we witnessed the atypical occurrence of declines in both stocks and bonds.
Despite it all, the U.S. economy continued to grow, and employment strengthened. Multiple manufacturing and services indicators pointed to expansion. The U.S. consumer’s financial condition is strong, although inflation increased at a rate higher than wages over the past year. Inflation remains a primary concern of consumers. Not only have housing prices increased dramatically over the past year, jumping 19%, but so have groceries and the price of gas at the pump. Inflation will likely continue to be a challenge as the year wears on, especially since the rise in housing costs is not yet fully reflected in inflation numbers.
Higher prices have given the Fed more urgency in its mandate to maintain price stability or average long-term inflation around 2%. Raising the fed funds rate by 0.25% at its March meeting was the first step, and the Fed expects at least six more increases this year to wind up at a median fed funds rate of 1.9% by year-end. This is significantly greater than its 0.9% forecast as of its December 2021 meeting. The Fed sees the median rate topping out at 2.8% next year. This has caused their real GDP forecast for this year to drop to 2.8% from 4.0% last December.
All of the above resulted in higher interest rates and a flattening U.S. Treasury yield curve to the point where the 2-year yield rose above the 10-year yield during trading on the quarter’s last day. A yield curve inversion often indicates the economy is in the later stage of a cycle. Inversions are viewed as historically reliable, though imperfect, predictors of recessions to follow within 7 to 34 months, though the average return of the stock market in the interim averages 19% (Source: Deutsche Bank). A factor contributing to the occurrence of an inversion is the Fed’s continued purchases of U.S. Treasury securities keeping its outsized balance sheet near $9.0 trillion, up from $4.2 trillion in February 2020, and $0.9 trillion in September 2008. This has the impact of keeping the 10-year yield artificially low.
The S&P 500 index ended the quarter with a strong 3.7% gain in March, but it wasn’t enough to overcome its losses in the first two months resulting in a quarterly loss of 4.6%. During the quarter, the index briefly dropped into correction territory with a loss of over 10% from its peak. The losses were led by technology with the tech-laden NASDAQ Composite index losing 8.9% in the quarter and dipping into a bear market at one point with more than a 20% decline.
International stocks struggled during the quarter due to COVID, the war in Ukraine, and a stronger U.S. dollar. Developed market international stocks lost 5.8%, while emerging market stocks declined 7.0%.
Diversification paid off across investment styles with value stocks experiencing a fraction of the loss of growth stocks. For example, U.S. large value stocks declined just 0.7%, while large growth stocks dropped 9.0%. Diversification across size also proved its worth with large stocks outperforming both mid and small caps year-to-date thanks to their strong returns in March.
Interest rates increased broadly during the quarter as investors began to incorporate higher inflation and Fed rate increases into prices and yields. The 10-year Treasury yield ended the quarter at 2.42% after starting the year at 1.51%. The shorter dated 2-year Treasury yield also ended the quarter at 2.42% after beginning the year at 0.73%. This rise in interest rates put the total return for the Bloomberg Aggregate Bond Index into negative territory for the quarter with a loss of 5.9%. Because of their lower interest rate sensitivity, high-yield bonds lost a bit less ending the quarter down 4.8%. To reduce potential losses in our clients’ portfolios, we are keeping individual bond ladders and bond fund durations (a measure of interest rate risk) lower than their respective benchmarks. The good news is the fed fund rate increase has already resulted in higher yields on cash holdings and will continue to do so as the Fed increases overnight rates throughout this year.
Alternative assets generally outperformed both stocks and bonds during the quarter, fulfilling their diversification purpose. The only exception was Real Estate (as represented by the FTSE All Equity REIT Index) which lost 5.3% during the quarter. Broad commodity prices rose 25.5% with oil up 33.8%, and gold up 6.1%. Lastly, the global hedge fund index only lost 1.2%. The war in Ukraine, raw materials shortages, and inflation in general would tend to keep these trends going.
Your Investment Management Team continues to diligently manage your portfolios, keeping risk in line with each account’s objective as the year progresses with its many challenges and unknowns. Our decades of experience, which include instances of similar conditions, has taught us the best path forward is to stick with the investment plan, making carefully considered course corrections as needed.
Should you have any questions or comments, please email us at BWealthManagement@broadway.bank.