The 1st quarter of 2022 saw the beginning of two conflicts. The first battle is figurative and financial in nature, featuring the Federal Reserve (Fed) commencing its anticipated assault on escalating inflation.
The second conflict is literal and lethal, featuring the brutal Russian war on Ukraine and tragic human suffering.
Both are expected to have persistent and profound impacts on the financial markets throughout the year. The fog of both of these battles likely will keep market volatility elevated and returns more subdued relative to the past few years.
The Fed followed through on its intention of aiming its policy arsenal on advancing inflation. Although its first volley of raising interest rates was only 25 basis points, the Fed openly suggested that a more aggressive campaign against inflation may be forthcoming in the form of larger increases in interest rates. Short maturity treasury bond yields surged about 150 basis points higher, while longer term yields rose roughly 75 basis points, resulting in the worrisome development of a dramatically flattening Treasury yield curve.
Flat yield curves have often been an early warning of recession. Credit spreads also widened materially. The result is that the bond market suffered its worst quarterly performance in years, with the Bloomberg Aggregate Bond Index declining approximately 6.0% through the 1st quarter, which was worse than the S&P 500® equity index market return.
The reverberations of war
The devastating Russian invasion of Ukraine has contributed a new variable into the global economy and financial markets. Russia and Ukraine, although both relatively small from a global economic perspective, are significant producers of commodities, especially energy and foodstuffs.
The destructive consequences of war are contributing additional inflationary pressures to the commodity markets. Meanwhile the far-reaching economic sanctions imposed on Russia and the surprisingly large number of multi-national companies that are opting out of doing business in Russia are adding additional pressure to already fragile global supply chains.
Impact on financial markets
In looking at major market index returns for both bonds and stocks, it is interesting to note the consistency of results. All the major asset sectors, from small cap equities to large cap growth to broad fixed income, have had negative returns in a range of roughly 4-7% through the end of March. However, these index numbers mask a wide dispersion of returns for the constituents that make up these indices.
Commodities and commodity-oriented companies vastly outperformed the broad market, with high double-digit returns, while many very highly valued growth stocks sharply declined. The common theme has been that real assets, stocks of companies with solid fundamentals, and value-oriented investments have vastly outperformed riskier counterparts across asset classes.
Prices, profits, and P/Es remain the keys to market performance
Prices. As mentioned, the Russian invasion has caused commodity prices, and especially oil, to surge. However, subsequent to the initial significant price spikes, oil and commodities prices more generally have come off the boil somewhat, although price volatility remains high. A more significant longer-term issue with inflation is labor price pressure and consumer inflation expectations, both of which continue to build.
The Fed seems to be factoring this into their more hawkish rhetoric about fighting inflation. The Fed’s offensive against inflation will continue. Equity market performance had been understandably weak at the onset of this policy change. However, more recently stocks have actually risen in tandem with bond yields, a possible sign that the equity market, at least for now, is more comfortable with the Fed’s tactics in restraining inflation and near-term economic prospects.
Profits. Corporate profitability has been the main buttress in supporting the equity market. Profit reports for the 4th quarter of 2021 were quite strong as the impacts of the pandemic began to recede. First-quarter earnings reports, coming out soon, will be carefully scrutinized regarding the impact that both input price pressure and escalating labor costs may have on profitability. It is expected that profits will moderate, but not collapse in the coming quarters. Moderating corporate profits also imply moderating expectations for equity performance.
P/E multiples. With most stock prices experiencing meaningful declines in the 1st quarter, even with strong profit reports, price-to-earnings (P/E) multiples declined. This reduction in equity market valuation is not surprising given the increased level of uncertainty and rising interest rates. Elevated uncertainty in this current environment will remain an impediment to any significant multiple expansion that could drive equity markets meaningfully higher. However, the relatively cheaper P/E market valuation and still more than ample levels of liquidity in the financial system will provide some level of support to the equity market.
Peering through the fog
The combination of the war in Europe and the Fed’s battle against inflation provides an unusually thick fog in which to navigate portfolios.
In such an environment, it is useful to let the beacons of solid fundamentals, high quality, and rational valuation be your guide, regardless of investment sector. In such a volatile environment, the discipline of rebalancing portfolios is also very important.
After the worst bond market performance in nearly two decades, some semblance of value is emerging in fixed income markets. However, with scant evidence of inflation receding, and the Fed now more on the offensive regarding monetary policy, expected returns remain muted. That being said, with two-year Treasury securities yielding well over 2% (after trading at 0.25% the past two years), the market is already pricing in many more rate increases.
Assessing value in longer maturity fixed income (10 to 30 years) is more challenging. On one hand, inflation remains high, resulting in negative real yields (yield less expected inflation) for long-term investors. On the other hand, if the flattening yield curve is correct in signaling rising recession risks, then long-dated bonds would be attractive at current levels given that inflation and interest rates would be expected to decline in a more difficult economic environment.
In the corporate and high yield bond markets, credit spreads seem fair given a still strong economy, low default rates, and ample liquidity in the system.
In short, bond yields are now more attractive than they have been in years, but it is in a highly uncertain inflationary environment. Given that there is little evidence of inflation retreating, long-duration assets still seem at risk. Therefore, the intermediate maturity fixed income sector seems like a reasonable risk/reward proposition currently. Adding yield through a focus on the credit and mortgage sectors also seems appropriate currently.
Stocks have proven to be resilient in the face of dramatically higher inflation, tightening Fed policy, surging interest rates, and war in Europe. In the 1st quarter, the large cap growth sector of the market initially sold off much more sharply than the value sector due to their greater sensitivity to higher interest rates.
Recently, this sector seems to be finding its footing from a relative performance perspective. The growth sector—and technology in particular—have some advantages over other more industrial, value-oriented sectors in that they are less impacted by input inflation, have pricing power, and are well capitalized. Although valuations are still high, this dynamic sector should still be a core holding in portfolios.
Value stocks were the stars during the first quarter, after years of lagging performance relative to growth. The value sector continues to have appeal, although it should be noted that the materials and energy sectors are heavily represented in this area of the market. However, with inflation expected to stay elevated, value stocks should continue their solid performance going forward as long as economic growth holds up. Value stocks tend to underperform when the economy slows or declines, as earnings growth becomes scarcer and investors turn to growth stocks.
The small cap area of the market has been in a state of churn. This market is not very homogenous in terms of the type of companies that fall in this area. A disproportionate percentage of companies in this space are unprofitable, especially in the biotechnology area of the market.
Companies without profitability have been particularly hard hit over the past quarter. However, a number of smaller, higher-quality companies with solid business and earnings fared relatively well. Therefore, generalizations about valuation in the small cap sector are difficult. In short, this is an area that requires astute security selection and careful active management.
International equities, and especially emerging market equities, underperformed U.S. indices during the quarter. There also was tremendous divergence in performance by country and sector within international indices, as Chinese stocks plummeted, and Russian stock trading was halted due to sanctions. Ultimately, Russian equities were removed from major emerging market indices as well, causing further confusion in this volatile market.
All this turmoil has caused international markets to now be priced at exceedingly low valuations. Even at such low valuations, there remains significant risk in international markets for obvious reasons. Caution still seems to be warranted in making an allocation to non-U.S. markets.