2022 First Quarter Investment Update
Many of the concerns addressed in our annual outlook continued to manifest themselves in markets during the first quarter. The most prominent was inflation, which was brought even more into focus with Russia’s invasion of Ukraine. The Consumer Price Index (CPI) index registered an 8.5% annualized growth rate in March, the highest since 1981. As inflation expectations ramped up, the Federal Reserve’s rhetoric on monetary policy shifted dramatically as they struggled to keep up with an increasingly overheated economy. At the start of the year, markets projected the federal funds rate to end 2022 around 1%; today, that number has risen to between 2.50-2.75%. The Fed also announced in their meeting minutes an outline to start shrinking their almost $9 trillion balance sheet, which we believe has contributed to the two-year stock market rally and historically rich valuations.
Difficult Quarter for Stocks & Bonds, But Value Leads Growth
There were very few sectors of the market spared by the repricing of interest rates and valuations, along with the rising geopolitical uncertainty.
Large-cap US stocks (as measured by the Russell 1000 Index) were down 5.1%, small-cap US stocks (Russell 2000) were down 7.5%, international stocks (MSCI EAFE) were down 5.9% and emerging markets (MSCI EM) were down 7.0%.
However, it was a very strong relative quarter for lower valuation stocks, as the market tended to punish richly valued and unprofitable companies. Across every equity category, value led growth, and lower volatility strategies outperformed their index in the US and emerging markets.
Among fixed income, US taxable bonds (Bloomberg US Aggregate Bond Index) were down 5.9% and municipal bonds (Bloomberg Municipal Bond Index) were down 6.2%. High yield and international bonds suffered similar setbacks, down around 4-5%. Shorter-term bonds had more muted losses due to their lower sensitivity to higher interest rates.
Alternative Investments are a Safe Haven
Besides energy stocks, the only other bright spot in the first quarter was in alternative strategies, which provided the expected diversification benefits during a volatile period for traditional assets. Managed futures strategies, which track commodities, currencies, and follow trends in these and other markets, were up about 9% for the quarter. Some of our other hedged equity managers, particularly in the merger and event-driven segments, were also positive for the month.
We expected market volatility to increase in 2022, and it certainly delivered in the first quarter. In an environment where there were few places to make money, our diversified portfolios lost less than their benchmarks, which is a key ingredient to long-term investment success. We do not believe it is wise or practical to attempt to time the market, but it is possible to avoid overconcentrating in areas that appear fundamentally expensive and pose more downside risk. In that respect, we are pleased our tactics this year have led to comparably superior results so far.
That said, it is not realistic to get every call right every quarter or even every year. There are always a few surprises in markets, and for us, one of them has been the strength of the US dollar. We believe this was due in part to its defensive characteristics as the events in Ukraine unfolded. It was likely also a product of the Federal Reserve’s aggressively hawkish tone since the beginning of the year. The Fed has “talked up” rates through active campaigning of policy moves from the chairman and governors. However, they have only implemented a single 0.25% interest rate increase so far. It is likely they are hoping that inflation will abate later this year and they will not have to tighten financial conditions so dramatically. Any pivot toward a more dovish tone or accommodative policy would likely put a halt to the dollar rally. If the US economy heads toward recession, we also believe the dollar will be under pressure.
There were already a myriad of challenges and uncertainties in the economy and markets entering 2022, and the Russia-Ukraine war added yet another variable to the mix. With the Federal Reserve acting serious about combating inflation via higher interest rates and balance sheet reduction, fundamentals appear to be gaining traction. We believe markets are still in the early stages of repricing assets following the excesses of money printing and loose financial conditions. Earnings announcements in the first quarter will provide a look at how well companies can maintain historically high-profit margins as they confront inflation and the fiscal drag from less government spending.
We continue to favor value-oriented and more defensive or low volatility equity strategies. Even with the stock market correction in the first quarter, growth stocks still trade at rich premiums to value stocks, and we now characterize them as just “very” instead of “historically” expensive. We particularly see good long-term opportunities in smaller stocks. We also believe international and emerging market stocks are valued very fairly or even cheaply despite the uncertainty of Russia-Ukraine and recession overseas.
In the bond market, we are leaning toward more defensive and longer-duration assets. We believe it is unlikely the Federal Reserve will get much more hawkish as inflation numbers near peak levels. As the various forms of financial tightening take hold, from individual borrowing costs to government debt service, we expect the yield curve will flatten (the Treasury curve already inverted between the 2 to 10 year segment briefly on March 31). If the bond market starts to price in higher recession possibilities in 2023, it’s likely that long-term interest rates will not drift significantly higher. We continue to see solid opportunity in non-dollar denominated bonds; as discussed prior, the dollar could be at risk if the Fed does not follow through on their expected commitments.
We believe alternative investments are well suited for this volatile market environment. There will likely be fits and starts in choppy trading through the remainder of 2022, and these funds will serve their purpose of lowering risk and providing uncorrelated returns.
The violent swings in stocks this year are beginning to show signs of an early-stage bear market, rather than a bull market “correction”. We do not think recessions or bear markets are toxic words, as many in financial media and the commercialized advice community seem to. If these events resolve excesses in the economy and asset valuations, they clear the deck for investors to pay fair prices and receive acceptable returns to meet their long-term financial goals. Please also keep in mind that the financial media typically define bull and bear markets by the major large-cap US indices such as the Dow Jones Industrial Average or S&P 500 Index. While we measure ourselves against these benchmarks among others, we actually see some of the least attractive return potential from large US stocks, particularly the biggest growth stocks in the NASDAQ.
We are, however, encouraged by other areas of the market that show promise and opportunity right now. Our plan is to steer portfolios in those directions; in doing so, we believe you will be well-positioned to withstand the recessions, bear markets and inevitable volatility that come from being a long-term investor. Thank you for your confidence in our team and advice.