After very good performance in 2021, US equities decidedly struggled in the 1Q of 2022. The S&P 500 followed up last year’s impressive 28.7% total return with a -4.6% decline in the recent 1Q. And it wasn’t just large-cap stocks that suffered in the quarter as both mid-cap and small-cap stocks fell by -5.7% and -7.5% respectively. Frankly, there was seemingly no place to hide to start this year with nearly all major asset classes experiencing negative returns. The standout winners were assets that benefit from higher inflation and not surprisingly commodities were atop that list, with the Bloomberg Commodity Index up an eye-opening 25.5% in the 1Q.
Typically, when equities are having a rough go of it, we can usually count on fixed-income allocations to serve as a ballast for portfolios, helping to offset any resulting drawdowns. Unfortunately, however, bonds also struggled in the quarter as evidenced by the bellwether Barclays US Aggregate Bond Index declining by -5.9%. Other fixed-income vehicles fared even worse as long-term Treasuries dropped -11% and US corporate bonds were off by -11.2% in the quarter. In short, it was the worst quarterly return for US bonds in 40 years.
With both equity and fixed-income asset classes experiencing headwinds so far this year, it begs the question: what’s going on? Good question! Currently, the investment landscape is not very accommodative for either stocks or bonds. The Fed announced months ago that its quantitative easing (QE) program would come to an end and quantitative tightening would commence in the form of several anticipated interest rate hikes. As a result, the 10-year Treasury yield started 2022 at approximately 1.5% and steadily climbed to near 2.4% by the end of March. Such a dramatic rise in interest rates drove most fixed-income prices much lower.
Why is the Fed raising interest rates? Primarily to combat rising inflation. Although at this point it’s almost a distant memory, there was a time when inflation was a non-issue and if anything, a moderate amount of inflation was desired. The Fed had stated that 2% average inflation was their target, with the word “average” being a new term for the Fed when it came to inflation. They no longer would raise rates once inflation first rose above 2%, but rather only after it averaged 2% or more for an extended period. The most recent annual inflation rate is 8.5% and the rolling 12-month average has been well above 2% since the second half of last year, so action by the Fed was in order.
Based on Fed Funds futures as well as consensus opinion, the Fed is expected to raise interest rates several times during 2022-2023, with the upper-range estimate being 11 hikes. An outcome of the Fed raising rates is the economy tends to slow down and even risks entering a recession. The proverbial “soft landing” for the economy is always the Fed’s goal but is almost never achieved. Instead, the Fed is typically “behind the curve” with inflation, meaning it’s arguably late in starting rate hikes and as a result goes too far with the number of rate increases, draining precious liquidity from the financial system and eventually pushing the economy into recession.
That said, there’s no guarantee a recession will result from this most recent cycle of Fed rate hikes. In fact, it’s important to point out that economic conditions today differ from past recessionary periods – in many respects, significantly. In prior client letters, we’ve discussed how the pandemic introduced several unprecedented events, from the shutdown of the global economy to the trillions of dollars in stimulus provided by both the Fed and US government. The pandemic effectively squashed demand for products and services by deferring consumer purchases. But once the economy gradually began to reopen, consumer demand surged as if on steroids, in large part due to the injection of massive stimulus. At the same time, supply channels which were shuddered by the pandemic could not keep up with the resurgence of demand and bottlenecks quickly developed. Rising inflation was the net result.
With the Fed halting QE and planning to raise interest rates multiple times over the next several months, in addition to the end of pandemic-related government aid, consumer demand will no longer enjoy the unprecedented tailwinds that came with the stimulus. Excess liquidity will dry up, likely reducing demand, which will help to alleviate and mend supply chain bottlenecks, which will ultimately work to reduce inflation. The main point being the Fed could raise interest rates fewer times than currently expected to achieve the goal of tempering inflation. As the economy slows and hopefully avoids recession, the 8-11 rate hikes currently priced into markets could get revised to perhaps 4-6 hikes or even less. While that still means interest rates head higher, markets move based on existing expectations and with this decline in the number of expected rate hikes, equities and bonds should respond positively to such a bullish change in expectations.
It goes without saying that these are very complicated times, arguably even more complicated than is usually the case. Given everything written above, not mentioned is the horrific invasion of Ukraine, which has further exacerbated inflation with the spike in crude oil prices and has also introduced the once-unfathomable spectre of World War III as another risk for investors to digest. There is a time and a place for making outsized portfolio exposures, but we believe now is clearly not that time. It’s never prudent to make big bets just for the sake of making big bets. Based on our research and analysis, more than a few key macro developments are currently in flux or at a crossroads and depending on how one breaks would likely affect all others in domino fashion. Although our stance has been generally defensive since late last year, at this point we prefer to take a wait-and-see approach before establishing more aggressive portfolio exposures.
The team at Measured Wealth wishes you all the best during the rest of 2022. As always, if you have any questions, feel free to call or email.
Ed Miller, CFA, CMT
Chief Investment Officer
Measured Wealth Private Client Group
Important Disclosures
Historical data is not a guarantee that any of the events described will occur or that any strategy will be successful. Past performance is not indicative of future results.
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