Happy Spring!
The early part of the first quarter resembled much of the previous two years, we coped with Covid-19 and its implications. As the quarter progressed however, we started to emerge from Covid-19 woes, experienced an unemployment rate closer to full employment, the labor force participation rate improved welcoming back some who had previously left the work force, and corporate profits remained strong. The Russian invasion of Ukraine has unfortunately caused significant shock, disbelief, and disruption on a humanitarian and economic level. The war has amplified concerns around ongoing inflation and supply chain challenges with mixed feelings on how our economy will stand up to the pressures.
2022 started the year similar to 2021, with COVID-19 cases spiking across the globe. The Omicron variant proved to be more contagious than past variants and caused additional disruption to a labor market that was already struggling with all-time high job openings and a shortage of workers. The variant further delayed plans to return to the office and for business travel to resume, while also causing production shutdowns and port closures at a time when the global supply chain was starting to show signs of improvement. Fortunately, Omicron was relatively short-lived and the pace of new cases fell much faster than we experienced with past variants.
This aided a recovery in the labor market and we have seen the number of available jobs fall for the second consecutive month after reaching a record high late last year. Rising inflation levels and economic uncertainty are a few of the factors providing incentives to return to work. Employers added 678,000 workers to their payrolls in February, which is the biggest gain in 7 months. Unemployment fell to 3.6%, moving closer to the 3.5% 50-year low level we were seeing prior to the pandemic. Household incomes also rose by 0.5% in February from the prior month, which is generally a good sign for consumer spending which is a key growth engine of our economy.
The problem however, is that the continued high levels of inflation and supply chain challenges were further exacerbated by the Russia/Ukraine conflict. Consumer prices rose 0.8% in February and 7.9% year-over-year, a 40 year peak, and the inflation rate is likely to be an even bigger drag in March due to surging energy prices.
Consumers and investors continue to send mixed signals about the future direction of our economy. On the one hand, consumers are excited about the prospect that the pandemic has finally come to an end and our labor market is showing signs of improvement. But on the other hand, investors are concerned about persistent inflation, what that means for Federal Reserve monetary policy, and how the Russia/Ukraine conflict affects energy/commodity prices and the health of our global supply chain.
| Asset Class | Benchmark | Q1 |
|---|---|---|
| US Stocks | S&P 500 | (4.60%) |
| US Gov't Bonds | BbgBarc US Govt Intermediate | (4.19%) |
| Cash | BbgBarc US Treasury Bill 1-3 Mon | 0.03% |
The rapid recovery in the labor market, combined with goods and wage inflation pressures, has forced the Federal Reserve to adopt a more neutral monetary policy. The market is pricing in the expectation for higher interest rates and therefore investors are discounting back the future expected cash flows of companies at higher rates, resulting in lower valuations. This caused longer-duration growth stocks (companies with cash flows that are further out or have high expected future earnings growth rates) to decline more than the broader market. This is evidenced by the Russell 3000 Growth index (-9.25%) significantly underperforming the Russell 3000 Value index (-0.85%) year-to-date. Value stocks have generally tended to outperform Growth stocks in periods of above-trend economic activity and rising interest rates. From a market capitalization standpoint, Large and Mid-Cap stocks (Russell 1000 -5.13%) have outperformed Small Cap Stocks (Russell 2000 -7.53%) so far this year.
After being down over 10% through mid-March, the S&P 500 recovered some of its losses in the last two weeks to end the quarter down 4.6%. The Energy sector is the best performing by a significant margin, up 39% year-to-date as oil prices rallied over $100/barrel due to the Russia-Ukraine conflict. The Utilities sector (+5%) is the only other sector in positive territory this year. The worst performing sector was the Communication Services (-12%) as Facebook (now called Meta) and Netflix, which make up roughly 25% of the sector, are both down over 30% this year.
During the 1st quarter of 2022, the bond market experienced a broad sell-off with interest rates rising to levels not seen since 2019. The inflation story was on the forefront of all investors’ minds as increases to Consumer Price Index (CPI) were reported at a four decade high. As a result, Chairman Powell and the other Federal Reserve members took a more hawkish tone on monetary policy decisions leading up to the March 16th Federal Reserve (“the Fed”) meeting. Indeed, investor market expectations quickly drove interest rates higher with the assumption we would see multiple rate hikes in 2022 including the potential for a 50 basis point jump at the May meeting.
Two-year interest rates, being more sensitive to near-term monetary policy actions than longer rates, increased dramatically which flattened the yield curve. This movement resulted in the 2 to 10-year maturity portion of the curve briefly becoming inverted and ultimately ending the quarter even. The U.S. 10-year treasury yield finished the quarter at 2.34% or 83 basis points (0.83%) higher than where it started the quarter at 1.51%, while the 2-year U.S. Treasury yield increased 161 basis points (1.61%) higher to 2.34% at quarter end after starting the quarter at only 0.73%. The invasion of Ukraine by Russia did give the bond market pause during the end of February and the beginning of March as market participants debated whether the Federal Reserve would be able to raise rates as anticipated. Ultimately, the Fed did vote to raise the Federal Fund rate by 25 basis points and gave verbal commitments to continue its battle to stave off inflation.
As bond yields move inversely to prices, U.S. bonds experienced one of the worst performing quarters in years. Interest rates rose across the board and geopolitical uncertainty increased volatility in the high grade and high yield credit markets. This combination of events left no safe haven with all sectors posting negative returns for the quarter.
As we head into the second quarter, we will be watching the Federal Reserve’s comments and next policy decision at the scheduled May 4th meeting. While rising interest rates may lead to performance headwinds in the short-term, as investors, we need to remember the important role that bonds play as an equity diversifier and the positive impact compounding interest at higher rates will have on building future income in portfolios.
Equity diversification was beneficial in the first quarter as market volatility picked up. Commodities, Master Limited Partnerships (MLPs), and Managed Futures have posted double-digit returns this year and are a few of the many equity asset classes outperforming the S&P 500 this year.
Fixed income diversification was a mixed bag in the quarter as rising rates and the conflict in Ukraine cause bond prices to fall and spreads to widen out. Uncorrelated bond categories such as reinsurance bonds were among the best performing fixed income asset classes. Other fixed income asset classes that protect against inflation and rising rates are Bank Loans, Treasury Inflation – Protected Securities (TIPS), and short duration securities. However, this benefit was more than offset by pressure from asset classes such as international bonds which were significantly impacted by the Russia/Ukraine conflict.
| Asset Class | Benchmark | Q1 |
|---|---|---|
|
Foreign Stocks |
MSCI EAFE |
(5.91%) |
|
Emerging Markets Stocks |
MSCI Emerging Markets |
(6.97%) |
|
US Mid Cap Stocks |
Russell Mid-Cap |
(5.68%) |
|
US Small Cap Stocks |
Russell 2000 |
(7.53%) |
|
REITs |
MSCI US REIT |
(4.06%) |
|
Commodities |
Bloomberg Commodity |
25.55% |
|
MLPs |
Alerian MLP |
18.81% |
|
Managed Futures |
Credit Suisse Mgd Futures Liquid TR |
13.54% |
|
Foreign Bonds |
FTSE WGBI Non-USD |
(7.13%) |
|
Emerging Market Bonds |
JPM EMBI Global |
(9.26%) |
|
US Inflation Protected Bonds |
BbgBarc US Treasury TIPS |
(3.02%) |
|
Floating Rate Loans |
Credit Suisse Leveraged Loan |
(0.10%) |
|
US High Yield Bonds |
BbgBarc US Corp High Yield |
(4.84%) |
|
Convertible Bonds |
ICE BofAML Convertible Bonds |
(5.41%) |
We are hopeful future peace negotiations among the Russian and Ukrainian leaders will bring an end to this war and peace to those that have experienced the greatest hardships. While this crisis may continue to create volatility in our markets and dampen the global economy short term, maintaining a long term outlook to investing is always a prudent approach and how we our able to serve our clients well in good times and in bad. As always, should you find yourself questioning your current situation, concerned about risk or outside factors, our team is always here to navigate you through it and answer any of your questions. Thank you.
Sincerely,
David B. Smith, CFA
Managing Director and Chief Investment Officer
