During the first quarter, U.S. stock markets recorded their first quarterly loss in two years and the U.S. bond market suffered its worst quarter in 40 years. The start of the Federal Reserve’s interest rate hiking cycle, persistently high inflation, and the Russian invasion of Ukraine, combined, creating a volatile quarter for both stocks and bonds.
The Fed Becomes Hawkish
The Federal Reserve has gone from remaining stubbornly dovish last year and claiming that inflation was “transitory” to feeling they are now behind the curve in combatting it. After raising rates 25 basis points in March, it is telegraphing a 50 basis point increase in May and plans to shrink the Fed’s $9 trillion balance sheet rapidly. This sudden change of heart has inverted the yield curve, with some short-term rates (the 2 and 10-year yields) now sitting above long-term rates, fueling concerns about a recession.
A study by BCA Research found that the gap between 2- and 10-year yields have inverted before seven of the past eight recessions. Indeed, the last time the 2/10 part of the yield curve inverted was in 2019 and there was indeed a recession – albeit one caused by the global pandemic. Many argue, that the current situation, created by pandemic stimulus and supply chain dislocations, is somewhat unprecedented and therefore not predictive. Indeed, the Fed put out a paper on March 25, suggesting the predictive power of the spreads between 2 and 10-year Treasuries to signal a coming recession is “probably spurious,” and suggested a better herald of a coming economic slowdown is the spread of Treasuries with maturities of less than 2 years. But while the Fed is comfortable that its attempt at a “soft landing” will not cause a recession, given its recent reversal on inflation, its credibility is somewhat tainted.
What Worked in Q1 2022?
Energy stocks performed the best in the first quarter due to soaring oil prices. While the S&P 500 TR Index market proxy was down 4.6% through March, the Bloomberg Energy Subindex TR was up a whopping 48%. Oil prices surged to $130 a barrel on concerns related to the Russian-Ukraine war, but ended the quarter just below the $100 level.
Commodity indexes also rallied during the quarter amid geopolitical uncertainty and continued supply shortages. Commodities have historically demonstrated resilience in rising rate and inflationary environments. Commodities, as represented by the S&P GSCI total return index – a benchmark of 24 commodities in agriculture, energy, and metals, was one of the top-performers in the first quarter, up 30%.
Source: Bloomberg, as of 3/31/2022. Energy represented by Bloomberg Energy Subindex Total Return (BCOMENTR Index), S&P GSCI represented by S&P GSCU Dynamic Roll TR (SPDYCITR Index), Agriculture represented by Bloomberg Agriculture Subindex Total Return (BCOMAGTR Index), Industrial Metals represented by Bloomberg Industrial Metals Subindex Total Return (BCOMINTR Index), Precious Metals represented by Bloomberg Precious Metals Subindex Total Return (BCOMPRTR Index), S&P 500 Index (SPX Index), Bloomberg US Agg Return Value Unhedged USD (LBUSTRUU Index). Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
The Case for Value
Value stocks were clear winners in the first quarter, with the S&P 500 Value Index besting the S&P 500 Growth index by 8.43%, down 0.17 versus -8.6%.
Will 2022 finally be the year that Value outperforms Growth, bucking the trend of the last two decades? There is certainly a strong case to be made for Value over Growth in the coming year:
- Rising rates favor value stocks – As many investors value stocks based on net present value (NPV) models, in rising rate environments, growth stocks tend to underperform cheaper stocks like cyclicals, financials, and energy (RBC – Lori Calvasina).
- Higher inflation a positive for value strategies – As inflation sits at the highest levels in 40 years, this squeezes the margins of companies without pricing power and/or high labor costs. While this may be company and/or industry specific, a study by Buckingham of stock market performance when inflation was in excess of 6%, shows at least in the past (going back to 1927), value stocks outperformed during these periods.
- Reopening trade favors value – The reopening trade is benefiting many beaten down and unloved segments such as airlines, energy, and travel, while the technology names that kept things going during the pandemic, like Netflix, Zoom, and Amazon, are now being forsaken.
The Case for Growth
In the month of March, growth stocks outperformed, outpacing their value peers. Certainly, some of that was attributable to reversal and bargain shopping as many stalworth growth stocks had overcorrected. But the biggest argument in favor of a growth stock recovery, is slowing economic growth. When earnings growth is scarce, investors are willing to pay up for growth, causing growth stocks to once again trade at a premium.
The Impact of Higher Interest Rates
The U.S. bond market suffered its worst quarter in four decades, with the Bloomberg U.S. Aggregate Bond Index, comprised mostly of U.S. Treasuries, investment grade corporate bonds and mortgage-backed securities—returned minus 6%, its biggest quarterly loss since 1980. We have been utilizing zero duration and hedged bond funds, along with floating rate products to hedge interest rate risk.
Besides the bond market, another market segment negatively impacted by rising interest rates is the housing market. Already, mortgage applications are down 40% from a year ago thanks to higher rates and higher prices that have priced many out of the market.
Many, like ETF manager Cathie Wood, think the “Fed is playing with fire”, not considering that other regions in the world like Europe and China remain in “difficult straights.” They think that aggressive Fed action is a mistake. Higher interest rates make it harder for businesses to grow to meet demand, further exacerbating shortages and price inflation.
At the very least, the Fed is playing a very difficult balancing act between curbing inflation and overshooting, killing economic growth and spurring a recession. -Jane Edmondson, EQM Capital and Indexes
There is an age-old adage that “a pessimist is an optimist with experience.” While the U.S. economy does appear to be at a precipice that could go either direction, my experience leads me to be optimistic that economic growth will prevail. Ultimately, there are enough positives on the horizon, such as a peaceful resolution in Ukraine, the resumption of post-pandemic normalcy, and the deflationary effects of technology, to put the Fed back on the sidelines and the growth story back on the field.
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