Market Summary and Outlook - First Quarter 2022
Key Points
Bonds declined during the first quarter amidst the Fed’s moves to tackle inflation. With economic data pointing to a slowdown, bond investors sought safety in long bonds and pushed the yield curve toward inversion.
Stocks sold off as sector rotation from Growth to Value picked up speed. We remain defensive and expect weakness in growth stocks to continue into the second quarter as corporate profits slow.
While we expect commodities to continue their long-term bullish trend, we will brace for any short-term setback if the economic slowdown gains momentum.
We expect gold to continue its uptrend as long as real rates remain negative.
We are cautious on many international markets given the potential for a global slowdown, and will be looking for pockets of growth.
We anticipate a lower inflation rate by yearend, based on the mathematics of the CPI calculation. However, as during the energy crisis of the 1970’s, we are aware that inflation could reach a new high in 2023.
Market Summary
Stocks and bonds continued their downtrends into 2022. Slowing economic data, rising inflation, and imminent Fed tightening weighed heavily on both asset classes during the quarter. Aside from a few knee-jerk reactions, the outbreak of the Russia-Ukraine conflict had minimal impact on U.S. markets as investors initially viewed the conflict as being short-term.
Bonds steadily declined during the quarter as the Fed ceased its bond-buying program and implemented its first rate hike in March. Expectations for a 2.50% yearend Fed funds rate caused the short end of the Treasury yield curve to start rising in earnest. With a tight labor market and the cost of capital increasing, small businesses confidence continued to wane. Mortgage rates jumped to 5.0%, raising the likelihood of a housing decline. Both the manufacturing and services sectors continued dropping, and consumer confidence reached an 11-year low. Investors began preparing for an economic slowdown by piling into longer-term Treasuries causing the yield curve to flirt with inversion.
For the first quarter of 2022, the Bloomberg U.S. Aggregate Bond Index dropped 5.93%. The Treasury index declined by 5.58%, the Municipal Bond index dropped by 6.23%, and the Corporate High Yield index declined by 4.84%.
Equities took a hit during the quarter as investors shifted into “risk-off” mode. Sector rotation provided some support to the major indexes, except for the Nasdaq, which was more exposed to rotation out of the bubbly “New Economy” stocks. For the first quarter of 2022, the S&P 500 returned -4.60%, the Nasdaq returned -8.95%, the Dow Jones Industrial Average returned -4.10%, and the Russell 3000 returned -5.28%.
Every S&P sector was down during the quarter, except Energy and Utilities. Long duration stocks (i.e., high multiples and low revenues) continued to slide. Hence, the Technology, Consumer Discretionary, and Communications sectors posted the worst returns during the quarter.
Source: YCharts
Value vs. Growth. Value stocks posted returns that exceeded their growth counterparts by an impressive 8.6%. The Russell 3000 Value Index returned -0.85% versus -9.25% for the Russell 3000 Growth Index.
Large Cap vs Small Cap. While large cap stocks ended the quarter ahead of small cap stocks, the two tracked each other relatively closely. The Russell 1000 Index returned -5.13% and the Russell 2000 Index returned -7.53%.
Commodities and gold were two bright spots during the quarter. Gold prices rose 7.55% to $1,953.80 t.oz. Gold miners returned almost 20%.
Commodity prices were rising prior to the Russia/Ukraine conflict, primarily driven by growing energy demand/supply imbalances. Following the outbreak, energy, grains, and industrial metals prices popped. Russia supplies about 10% of global petroleum production, 20% of global natural gas, 18% of global wheat, and 15% of global fertilizer exports. Commodity investors quickly assessed the higher likelihood of lower supplies in the future.
For the first quarter of 2022, the Dow Jones Commodity Index returned 25.92%. Within the index, Energy returned 46.71%, Grains returned 25.60%, Industrials metals returned 17.04%, and Livestock returned 3.03%.
Dispersion amongst the major cryptocurrencies was high during the quarter. XRP was the best performer returning 2.38%, while Solana was the worst at -30.03%. Bitcoin came in flat, while the rest were well entrenched in negative territory.
Market Outlook
With the Fed raising rates into a slowing economy, the long end of the yield curve continues to flatten as the short end rises. This bearish signal suggests that investors are gearing up for an economic slowdown and seeking safety in higher maturities.
If the Fed is engaging in demand destruction to reduce inflation, then the bond market is correct in forecasting a 2.5% Fed funds rate by yearend. With the Fed planning at least a 50-basis rate hike in May, we expect volatility in bonds to persist.
Equity investors appear to still believe in the “Fed put” fairy and are not yet convinced the Fed will raise rates through yearend. With 2022 being an important election year, we will watch this closely to anticipate any back pedaling by the Fed. We remain defensive and continue to favor value stocks over growth stocks. While many of the bubbly Growth stocks have given up some of their recent gains, we think there is more to come. Corporate profits overall will shrink as companies face higher costs associated with a tight labor market in conjunction with slower economic growth. For now, we expect continued weakness and higher volatility in equities.
We are concerned about international securities, particularly those in Europe. The stocks of most European countries have significantly underperformed U.S. stocks, since the ECB introduced its negative interest rate policy in 2014. Draconian lock down measures and a failing energy policy do not give us much confidence in the region, economically, at this point in time.
As long as inflation remains higher than nominal rates, we expect the price of gold to continue its uptrend. We expect prices for many commodities to remain in a long-term bull market, given the vast amount of energy needed to operate our old (and new) economy (e.g., agriculture, manufacturing, transportation, mining, digital infrastructure). Lack of energy supply relative to demand may keep energy—and other commodity prices—at higher levels for several years. That being said, we recognize commodity prices can dip during a recession or economic slowdown. While such a move may change our commodity positioning in the short run, it would not change our long-term view.
We expect inflation to peak in 2022 and end the year at a slightly lower level. As the effects of the government’s stimulus roll off the year-over-year monthly CPI numbers, we do not think higher energy and food prices will drive inflation to new peaks. We expect housing and durable goods to start rolling over before yearend for two main reasons: (1) The majority of the “At-home” workforce has relocated and/or remodeled. (2) Mortgage rates are over 5%. Although we expect a lower inflation number for 2022, we do not yet see this as a trend back to 2.0%. We recognize that higher inflation may be with us for a few years, and that a lower inflation rate in 2022 may be followed by a higher rate in 2023.
Over the long run, we remain optimistic about the opportunities for investment as the economic landscape evolves and newer technologies paved the way for new areas of growth. In the short run, we continue to pay close attention to new data and information and will keep you informed of any changes to our expectations.
DISCLOSURES
SBC Investment Management’s Quarterly Market Summary and Outlook is intended to communicate current economic and capital market information along with the informed perspectives of our investment professionals. All expressions of opinion are subject to change. Past performance may not be indicative of future results. There is no assurance that any of the trends discussed will continue, or that any of the forecasts will occur.
You should not construe any information in this publication as investment, financial, or any other professional advice. Nothing contained in this publication constitutes a recommendation, endorsement, or an offer to buy or sell any securities or other financial instruments. You should conduct your own research or speak to your investment advisor before investing.
SBC Investment Management prepares this material as a resource for its clients. This content is for informational purposes only and does not address the circumstances of any particular individual or entity. You may contact us to discuss the content of this publication within the context of your own financial situation.