This year started off with a stark reminder that the markets don’t always move higher. After two years of strong market performance, this quarter saw both stocks and bonds sell off. This marks the eighth time since 1990 that both asset classes had a negative return in the quarter and the first time this has happened since 2018. A spike in energy prices, concerns over the war in Ukraine, and fears that inflation is unlikely to moderate contributed to this quarter’s sell off. The Federal Reserve (Fed) raised interest rates for the first time since 2015. The Fed has also changed its messaging to become more aggressive with its policy moves to address inflation.

We typically don’t spend much time discussing bonds in our Viewpoints because they usually are a boring investment in your portfolio. So what happened to cause them to have their worst quarter in over 30 years? Investors take two sets of risks when investing in bonds: interest rate and credit risk. This quarter’s interest rates were the culprit to trigger sell off in the bond markets. Short-term rates (2 Year Treasury) moved from 0.73% at the beginning of the year to 2.28% at the end of March, and long-term interest rates (10 Year Treasury) moved higher by 0.8% in the quarter. The interest rate moves are a response to the inflation headlines we have been seeing since last year. The Fed is planning to raise rates more aggressively over the next year to help fight inflation. Investors are anticipating these moves and have pushed rates higher, which causes bond prices to drop.

While the news was mostly negative as we start 2022, there are have been some positive market events. The S&P 500 has rallied 9% from the market lows seen in March. The S&P 500 sold off around 13% before this rally to end the quarter down 4.6%. Most sectors in the markets sold off, but two industries managed positive returns. Shares in energy stocks rallied by 37% in the quarter. Crude oil and natural gas prices spiked by 42.7% and 39.2% in reaction to sanctions placed on Russia after it invaded Ukraine. The only other sector to post positive returns were utilities. They gained 1.7% in the quarter. Investors shift to utilities during times of volatility because of their defensive characteristics. The worst performing sectors were communication services (-11.46%) and consumer discretionary (-9.51%).

Investment Strategy

In our March Investment Committee Meeting, we removed our overweight holding in stocks and went back to a neutral or equal weighting to our target asset allocations. Over the past two years, our overweight holding in stocks has served us well, but the investment environment has changed given the inflation and interest rate outlook. Our stock allocation in the value and low volatility factors worked given the sell off in the broader markets. These strategies are tailor-made for the current market environment because of their defensive characteristics.

Outlook

Our outlook has become more clouded since our last Viewpoints in December. We had expected to see an increase in market volatility, but the moves were even greater than anticipated. We are more cautious than a few months ago, but there are still reasons to expect modest gains in stocks this year. Our expectation is the worst of the bond sell off is behind us and will slowly add to our bond holdings over the next few months.

The list of items to be pessimistic about has grown considerably in 2022. There are three that we feel are worth discussing in more detail. Higher energy prices act like a tax on the economy. When there are spikes like we have seen this year, it can serve as a catalyst for a recession. Swift moves in energy prices can cause a shock to economic activity that can precede a slow down in growth. Not all previous surges in energy prices have led to a recession, but this is something we’ll continue to monitor.

Inflation and energy prices go hand in hand. The consensus view was that inflation would worsen early this year before moderating in the second half. This was before the surge in energy prices and heightened geopolitical risks after Russia invaded Ukraine. Higher prices dominate headlines and are impacting consumer sentiment but not yet hitting consumer spending. There are early signs that supply chains issues are beginning to ease which should help reduce some pricing pressure. Higher wages continue to persist and are unlikely to diminish until more people rejoin the workforce.

Interest rates are the final issues that have us concerned. The move in short-term interest rates was the largest percentage increase since the 1980s. The reason rates jumped so much is in anticipation that the Fed will have to be more aggressive to tame inflation. The Fed’s policy has to play catch up to the market at this point which we believe should limit future interest rate moves (in the market) in the near term. In our opinion, there is a limited risk of owning bonds at current levels. The Fed has a tricky job over the next year. They need to raise rates to cool the economy off just enough to tame inflation but not too much to cause a recession. This is referred to as a “soft landing,” which have they have engineered in the past but it could be a challenge in this environment.

The headlines all seem dire, but there are still reasons to be optimistic that stocks will move higher from current levels. Over the next 12 months, earnings growth continues to look strong at around 8%. Earnings growth tends to drive stock returns over the long term. Corporations remain flush with cash and have just spent the most ever buying back their stock. We expect companies to stay aggressive in buying back shares through the rest of this year. Lastly, because we are now seeing monetary policy changes, this does not mean that stocks can’t perform well. As discussed in December, stocks tend to have positive performance early in the Fed rate cycles.

This has been a difficult start to the year but this is not the time to panic, nor the time to get aggressive. We stress test our investment strategies for different market conditions, including what we see in this environment. This is an excellent time to remind you of two of our firm’s investment principles; Focus on the Long Term & Don’t Let Volatility Derail You. We will focus on how your portfolio should perform over the next several years, not the next few weeks or months, while removing emotions during periods of market volatility.

US Market Viewpoints - Q1 2022