by William Henderson, Chief Investment Officer
Major U.S. stock market indexes gave back some of their March gains as inflation pressures persisted, the Russia / Ukraine war dragged on and comments from the Fed about balance sheet reduction weighed on investors’ concerns. Conversely, pockets of good news persisted, oil prices, for example, again fell further and strength in the labor markets continued. For the week ending April 8, 2022, the Dow Jones Industrial Average fell -0.3%, the S&P 500 Index fell -1.3% and the NASDAQ, an index representing growth stocks which are more sensitive to higher interest rates, fell by -3.9%. Overall weakness in the equity market continues and year–to-date returns remain solidly negative. Year-to-date, the Dow Jones Industrial Average is down -3.9%, the S&P 500 Index is down -5.5% and the NASDAQ is down -12.2%. News from the Fed about continued rate hikes and balance sheet reduction weighed on bond markets and the 10-Year U.S. Treasury bond rose an additional 37 basis points to 2.76%. After starting the year yielding 1.51%, the 10-Year Treasury is up a stunning 125 basis points so far in 2022 and at its highest level since March 2019. (See the chart below from Valley National Financial Advisors and YCharts showing the 10-year U.S. Treasury rate).   

While trying not to seem repetitive, the underlying fundamental strength of the U.S. economy (labor markets, consumer heath, bank balance sheets, corporate earnings) does not seem to counter the headwinds of higher inflation and higher interest rates. This week we will get some additional information around inflation as the monthly and yearly U.S. Consumer Price Index change for March 2022 is released on Wednesday. The previous YoY (Year Over Year) reading was +7.87% and a level at or higher will certainly give the Fed all the air cover it needs to aggressively raise interest rates further. Friday begins the release of First Quarter earnings and banks will be first to report. Expectations for the first quarter are low compared with previous quarters. According to FactSet, analysts surveyed expect EPS (Earnings Per Share) increases of S&P 500 companies to average only +4.5%; which would be the first time in two years that earnings growth did not top +10%.

Turning to the Russia / Ukraine war and market implications, there was a small piece of information that may help explain why the massive move upward in the Russian Ruble. China and Russia announced commodities trading between the two countries using a Yuan / Ruble currency conversion trade. Traditionally, commodities such as oil, that trade on international markets must be traded in U.S. Dollars only. Information around the China / Russia trade has helped to buoy the Ruble bringing the level back to pre-invasion levels. (See the chart below from Bloomberg).   

Trading outside of the U.S. Dollar has allowed the Ruble to rebound and shows how countries outside of NATO, China in this case, are helping Russia deal with crippling economic sanctions imposed by Western nations. Sadly, this gives us no reason to expect the Russia / Ukraine war to end anytime soon. 

Next week (April 18) brings the due date for Americans to file their 2021 tax returns. Most Americans are expecting refunds on their tax filings. A piece by Goldman Sachs noted that expectations are for refunds to exceed recent years due to the expanded tax credit and other fiscal transfers (See the chart below from the Department of the Treasury and Goldman Sachs).

Additional cash into consumers’ pockets over the coming few weeks will pile onto the cash they have already accumulated over the pandemic from increased savings, reduced spending, and government stimulus payments. In the face of rising costs of many consumer goods and services, this additional cash will give consumers a needed cash cushion. Lastly, remember that more than 60% of the U.S. economy is consumer driven and a healthy consumer flush with cash and employed always leads to continued economic growth. 

by William Henderson, Chief Investment Officer
Volatility and uncertainty are the best two words to succinctly describe the first quarter of 2022 and, as we have always said, both of those are bad for markets. Markets like boring and we did not get a lot of boring in the first quarter of 2022. Instead, we had continuing high inflation data, Russia starting a war with Ukraine, and the first Fed rate hike since December 2018. Over the course of the quarter, we saw violent swings in the stock market and huge intra-day moves in prices, which were largely attributed to uncertainty around the Russia/Ukraine war. War in that region severely impacted prices for certain commodities and strained an already stressed market still suffering from global supply chain issues due to the pandemic. Ukraine and Russia are large producers of oil, natural gas, wheat, and certain rare early elements such as palladium which is used to make catalytic converters for cars and trucks. Additional shortages in these critical commodities immediately spiked higher prices across the board and sent overall inflation numbers higher. 

Quarter-end returns do not accurately reflect the markets’ violent swings during the quarter. Looking at the chart below from Valley National Financial Advisors and YCharts, we see the quarter-end numbers for each major market index.   

While the chart shows the NASDAQ at -9.1% for the quarter-end March 31, 2022, at the bottom of the quarter, the NASDAQ was down over -20%. The chart reflects the huge move upward during the month of March as the risk-off trade faded and investors moved again to buy equities. For the quarter-end March 31, 2022, the Dow Jones Industrial Average fell -4.75%, the S&P 500 Index fell -4.95% and the NASDAQ fell -9.10%. Fixed income investors fared no better as the Barclays Bloomberg U.S. Aggregate Bond Index (a widely used measure of fixed income investment performance) fell -6.12% in the first quarter. The benchmark 10-Year U.S. Treasury bond started the year at 1.52% and ended the quarter 80 basis point higher at 2.32%. 

Around mid-March, the markets forged a dramatic turnaround as investors believed equities fell enough now warranting buying again. In our opinion, the markets were simply focusing on the strength and solid fundamentals underlying the U.S. economy: corporate profitability, bank health, the strong labor market, and consumers’ overall financial health. While these factors alone were not enough cure all the world’s ailments, specifically the Russia/Ukraine war, they were enough to pull investors back to U.S. equities. 

Corporate profitability, while slowing a bit so far this year, hit a record in 2021, and is expected to continue its upward trend in 2022. For the full year 2021, pre-tax profits rose 25% to roughly $2.81 trillion, which more than outpaced the 7% rise in consumer prices over the same stretch; proving that companies were able to pass on to their customers much of the underlying spike in materials and labor costs.  (See the chart below from the U.S. Commerce Department showing U.S. pre-tax corporate profits 2007-2021.)   

The labor market continues to be strong with new jobs being created each month. The unemployment rate fell to 3.6% in March from 3.8% a month earlier, quickly approaching the February 2020 pre-pandemic rate of 3.5%, a 50-year low. While low, the jobless rate helps to boost wages, higher inflation continues to impact workers pockets as prices for basic goods like gasoline and food creep higher each month. (See the chart below from the Federal Reserve Bank of St. Louis showing the unemployment rate since 1950). 

As mentioned, corporate profitability shows that companies have been able to pass on inflationary prices of materials to the consumer. Further, more people are working as evidenced by the unemployment rate. Certainly, these two factors coupled with global supply chain issues and commodity shortages exacerbated by the Russia/Ukraine war have impact inflation beyond the Fed’s 2.5% target rate. Hence, Fed Chairman Jay Powell’s response by raising interest rates at the March 2022 FOMC meeting. Given where inflation and employment levels are, we expect, along with all Wall Street economists, more rate hikes to follow in 2022. For a visual of how dramatic the inflation spike is, see the chart below from the Federal Reserve Bank of St. Louis showing the Median Consumer Price Index (common gauge of inflation) 1985-March 2022.   

There’s an old Wall Street maxim that states: “higher prices cure higher prices.” Essentially, stating that as prices increase, fewer buyers will emerge and thereby decreasing demand and high prices. In the current case, we have very healthy consumers with a lot of cash in their coffers accumulated over the past two years as spending on leisure activities was practically halted yet cash continued to build up from savings and government stimulus funds widely distributed to Americans. M2 – the measure of the total U.S. Money Supply stands at a record $21.8 Trillion, giving consumers a lot of cash to spend – eventually. (See the chart below from Valley National Financial Advisors and YCharts showing M2). 

“Eventually” is the key word here. The second quarter of 2022 brings Spring and the widespread lifting of pandemic-related lockdowns. With the grand reopening of the U.S. economy, consumers will be released to spend and enjoy travel, leisure, and other expensive activities – all at the newest, latest, and greatest “higher prices.” “High prices cure high prices.” 

While the pandemic in the United States seems well behind us, other parts of the world are still suffering its devastating effects. For example, China continues to impart severe lockdowns on whole regions in an attempt to quell the spread of COVID-19. Further, the Russia/Ukraine war is far from over resulting in continued disruptions in key commodities such as oil and wheat, which are dramatically impacting prices in the EU region and beyond. The U.S. is not immune to the pandemic or inflation and the Fed continues to watch both reminding us along with way that their dual mandate of full employment and 2.5% annual inflation are front and center for Powell. While the first quarter of 2022 produced negative returns for stocks and bonds (a very rare event), we remain positive on the economy and the markets for the remainder of the year with a word of caution for investors. Volatility will be present based on continuing unrest due to geopolitical events and continued pressure due to inflation, which will certainly shape the direction and severity of interest rate hikes by the Fed.