The S&P 500 gave up 4.6% over the opening quarter of 2022, ending a run of seven consecutive quarters of gains. Stocks sank as the Federal Reserve (Fed) raised the federal funds rate by .25% in March to fight inflation, which reached a 40-year high of 7.9% that month. Additionally, markets were jolted by the Russian invasion of Ukraine. Overseas, the MSCI EAFE Index fell 5.9% while the MSCI Emerging Markets Index dropped 7%. Fixed-income markets experienced their worst quarterly showing in decades, with the Bloomberg U.S. Universal Index falling 6.1% as bond yields jumped in response to high inflation and the Fed’s first rate hike since 2018. After a poor start to the year, stock return expectations for 2022 are modest and highly dependent on inflation and its impact on corporate earnings. Fixed-income investors face a challenging environment, with returns for U.S. investment-grade bonds likely to remain negative.
The S&P 500 declined 4.6% over the first three months of 2022, snapping a seven-quarter streak of gains for the large-cap index. Before mounting a recovery in March, the S&P 500 had fallen more than 10% from its December 2021 high, meeting the technical definition of a correction. The technology-heavy NASDAQ Index dropped more than 20% from its recent peak and entered bear-market territory in early March before recovering slightly.
In the face of the highest inflation in 40 years and near record-low unemployment, the Fed raised its federal funds rate by .25% in March and signaled six more similar hikes in 2022 alone. The rate hike marked the unofficial end of years of ultra-accommodative monetary policy by the Fed and weighed on the returns of growth stocks, whose valuations tend to be negatively impacted by rising interest rates. The quarter was also marred by the Russian invasion of Ukraine. The invasion increased global uncertainty and pushed commodity prices higher. The confluence of factors caused the CBOE Volatility Index (VIX), which is regarded as the fear index, to its highest level since October 2020.
Nine of the underlying 11 sectors within the S&P 500 dropped during the quarter, with growth sectors such as information technology, consumer discretionary, and communication services experiencing the deepest declines. The two sectors to rise for the quarter were energy and utilities. On the strength of surging oil prices, the energy sector, which represents just 2.7% of the S&P 500, rose a meteoric 39% over the quarter. In March, Brent crude oil topped $120 per barrel for the first time since 2012. Oil started the year below $80 per barrel and ended the quarter above $100 per barrel.
Large-cap stocks proved more resilient than small-cap stocks, and value stocks gave up less ground than growth stocks. The Russell 1000 Value Index declined just .7% while the Russell 1000 Growth Index fell 9%. After years of outperformance by growth stocks, the pendulum swung toward value stocks, which historically outperform growth stocks when interest rates and inflation are rising.
After a relatively strong first two months of the year, international stocks experienced deeper drawdowns than their domestic counterparts in March. The MSCI Emerging Markets Index dropped 7% during the quarter. In late February, Russian forces invaded Ukraine, the largest conventional military attack conducted since World War II. In early March, index provider MSCI declared Russian stocks “uninvestable” and removed Russia from its Emerging Markets Index. Although accounting for a relatively small percentage of the index, their removal contributed to the losses in the quarter. Elsewhere, stocks in China, the largest weighting within the MSCI Emerging Markets Index, tumbled 14.2%. In its struggle to contain the spread of the Omicron variant of COVID-19, China imposed widespread lockdowns across the country.
Meanwhile, the MSCI EAFE Index of international developed stocks retreated 5.9%. Countries most dependent on Russia for energy imports, chiefly among them Germany, were hardest hit during the quarter. The European Union (EU) receives forty percent of its natural gas from Russia. Similarly, Russia represented roughly a quarter of the EU’s crude oil imports in 2021. To date, the EU is yet to impose any sanctions on energy imported from Russia. However, elevated oil prices are crimping growth expectations in the region and analysts have cut growth estimates by about .50% for 2022.
Over the first three months of the year, the Bloomberg U.S. Aggregate Index fell 5.93%, its worst quarterly showing since 1980. The broader Bloomberg U.S. Universal Index fell an even deeper 6.11%. The quarter was marked by a rapid increase in U.S. Treasury yields. The yield on the 10-Year U.S. Treasury marched .87% higher during the quarter, starting at 1.51% and ending at 2.38%. The yield on the 2-Year U.S. Treasury raced 1.70% higher during the quarter, starting at .73% and ending at 2.43%. The highest inflation in four decades coupled with low unemployment caused the Fed to announce an aggressive rate hike campaign with a target of 2.75% to 3% on the federal funds rate by the end of 2023. The market quickly adjusted to the Fed’s projections and yields for all bonds jumped, with shorter-term bonds experiencing the largest increase.
Many market observers view an inverted yield curve as a harbinger of economic recession. In fact, the past six recessions in the U.S. were all preceded by a higher yield on the 2-Year Treasury than the 10-Year Treasury bond. That said, correlation does not equal causation. Furthermore, in these past six cases, the onset of recession from the time of yield-curve inversion has ranged from six months to three years. Finally, it is worth noting that the Federal Reserve Bank of New York uses the 3-Month and 10-Year Treasury spread to help predict recessions. At the close of the quarter, the yield on the 3-Month U.S. Treasury stood at .53%, 1.85% lower than the yield on the 10-Year U.S. Treasury.
U.S. gross domestic product (GDP) grew at an annualized rate of 6.9% over the fourth quarter of 2021, the latest period for which data is available. Economists were quick to point out that inventory restocking contributed to 4.9% of the 6.9% increase. U.S. real GDP grew 5.6% over 2021, its fastest rate of growth since 1984. In March, the Fed projected U.S. real GDP to grow 2.8% in 2022, revised down from its projection of 4% in December 2021. Growth is projected to slow to about 1% in the first quarter as inventories normalize and increase in subsequent quarters.
The U.S. unemployment rate fell to 3.6% in March, closing in on the pre-pandemic figure of 3.5% reached in February 2020, then a 50-year low. The percentage of the population that is working or actively looking for work, known as the labor force participation rate, rose in March. The labor force participation rate has been gradually rebounding since hitting a pandemic trough in April 2020. The labor market is extremely strong and is sustaining positive consumer sentiment despite high inflation.
In the face of low unemployment and elevated inflation, the Fed increased the federal funds rate in March by .25%, to a target range of .25% to .50%. The move marked the first increase in the federal funds rate since 2018. At its mid-March meeting, the Fed signaled it would raise the federal funds rate in .25% increments six more times in 2022. Days after the mid-March meeting, however, Fed Chairman Jerome Powell indicated that the central bank is prepared to raise the federal funds rate by .50% increments if needed. The Fed is now tasked with engineering a so-called “soft landing,” a situation in which inflation decreases and unemployment holds steady.
Somewhat overlooked, the Fed also ended its monthly purchases of Treasuries and mortgage-backed securities in March. From June 2020 through October 2021, the Fed purchased $120 billion in Treasuries and mortgage-backed securities each month. The tapering of these monthly purchases began in November 2021. The largest buyer exiting the market could contribute to higher intermediate and longer-term rates in the future.
Investors have witnessed a rough start to 2022, with virtually every asset class falling with the exception of commodities. Against this backdrop, it is easy for individuals to succumb to pessimism. The VIX, also known as the fear index, reached its highest level since October 2020 in March. Historically, VIX readings above 30 have served as contrarian indicators of excessive pessimism and stocks have performed quite well in the aftermath. U.S. unemployment is closing in on its pre-pandemic levels and household net worth is at an all-time high. Furthermore, an increase in the labor force participation rate and moderating private sector average hourly earnings growth indicates wage push inflation may be slowing. The Fed’s pivot from expansionary monetary policy to contractionary monetary policy is indicative of an economy on sound footing. U.S. GDP grew 5.6% in 2021, its fastest rate of increase since 1984, and is forecast to rise 2.8% over 2022—above its average over the last decade. During the last 12 rate hike cycles, stocks moved higher in 11 and only fell during the 1974 OPEC oil crisis where oil prices quadrupled. However, the outcome for domestic stocks and bonds will primarily be driven by the Fed’s ability to contain inflation and convince investors that inflation will trend lower in the coming quarters.
International and emerging market stocks are trading at attractive valuations and most countries have modest inflationary pressure compared to the U.S. Consequently, global central banks are not aggressively raising rates and potentially reducing growth. International valuations present a relativity attractive alternative to domestic stocks and in addition, international equities generally outperform U.S. stocks when inflation and interest rates are trending higher. Low-interest rates and inflation, which are beneficial for growth stocks, helped boost domestic relative returns for more than a decade. This trend is reversing and is supportive of more value-based stocks, which make up a larger percentage of international equity indices compared to the U.S.
Fixed-income markets logged their worst quarterly showing in decades, with the Bloomberg U.S. Universal Index falling 6.1%. Its unlikely interest rates will continue moving higher as quickly as they did in the first quarter, but in general, the trajectory of rates will likely be to the upside. Real interest rates, after adjusting for inflation, are negative and investors will ultimately seek positive real returns, meaning inflation will need to decline or nominal rates will keep marching higher. With the backdrop of high inflation and the Fed embarking on a rate hike cycle, investors should prepare for a second straight year of negative returns for bonds.
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Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
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