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. 

by William Henderson, Chief Investment Officer
There was considerable volatility in the stock market last week, much like we have seen thus far in all of 2022. However, each major market index managed to chalk up a gain for the week. The Dow Jones Industrial Average posted a meager +0.3%, the S&P 500 Index rose +1.8% and the NASDAQ moved higher by +2.0%. Trends are always risky to call here, but that gives us two weeks in a row of positive returns on the markets and certainly a little bit closer to positive returns for the year. Year-to-date, the Dow Jones Industrial Average is down -3.6%, the S&P 500 Index is down -4.4% and the NASDAQ, which represents growth stocks is down -9.3% in 2022. While stock market returns were positive, the bond market handed investors a bad week with the 10-Year U.S. Treasury rising 34 basis points to 2.48% from 2.14% the week before, the highest level since September 2019. Bond yields are reflecting two key points in the markets: 1) The Fed’s new tightening regime, which began when the FOMC (Federal Open Market Committee) raised interest rates by 25 basis points and further pointedly stated up to six more rate hikes will follow; and 2) Persistent inflation that is running at 40-year highs.

During the press conference after the FOMC announcement about the rate hike, Fed Chairman Jay Powell was certainly bullish on the economy, stating clearly, “the American economy is very strong and well positioned to handle tighter monetary policy.” The Fed is using their toolkit to quell runaway inflation with the expectation that higher short-term rates will not slow the economy. Shorter-term bond yields are already reflecting a lot of the expected Fed tightening yet to come. Two-Year U.S. Treasury yields are up 75 basis points in March and have risen 162 basis point in 2022 to 2.35% currently. Economists like to measure the so called “10s-2s spread,” meaning the spread in yield between 10-Year rates and 2-Year rates. Often, but not always, this measure has been used to predict a slowdown in the economy. (See the chart below from Valley National Financial Advisors and YCharts showing 10s-2s spread over the past year.) 

While not yet negative, the spread has come down drastically over the past year and is now nearly flat – meaning you get extraordinarily little additional yield when buying a 10-Year U.S. Treasury (2.48%) compared to a 2-Year U.S Treasury (2.35%). This curve has flattened a lot this year reflecting the tighter monetary policy of the Fed and softer economic growth expectations for 2022 and 2023. This move in rates is in sharp contrast with Chairman Powell’s comments around strong expectations of U.S. economic growth and could simply be that the 2-Year U.S. Treasury has already priced in most future rate hikes. 

It is important to understand that while interest rates are rising, they are not yet restrictive. Borrowing rates such as bank loans and mortgage rates remain low, offering borrowers attractive levels when expanding businesses or buying houses, confirming there is sufficient strength for consumers and businesses to absorb higher rates. Certainly, the strength of the labor market alone gives us confidence in the economy. Job openings remain high, unemployment remains at record lows and consumer confidence while falling a bit is still solid, especially given the $2 trillion in excess accumulated savings behind American households. Finally, we have pointed out here previously that stock markets have shown positive performance in 11 of the 12 previous rate hike cycles; again, showing that rising interest rates, especially from all time low levels, do not spell disaster for the economy. 

As mentioned above, mortgage rates are increasing along with all interest rates but, by historical measures, mortgage rates remain low and still offer future and existing homeowners attractive borrowing levels. (See the chart below from FactSet showing 30-year mortgage rates over the past 50 years).  

Higher mortgage rates will not completely cool the hot housing market, but they could quell the strong increases in home prices we have seen over the couple of years. This act alone will help cool overall inflation levels and assist the Fed in that goal. Housing continues to be a strong component of the economy and leading housing indicators such as new home sale surveys and building permits remain elevated. 

We remain cautiously optimistic on the stock market and the economy, for the reasons suggested above. The Russia/Ukraine war drags on with little mention of real cessation of aggression by Russia. The war continues to impact the energy markets specifically supplies of natural gas and oil to European Union regions, and some odd commodities such as palladium. Overall, the markets are dragging on and anticipating the end. There is sufficient expected growth in corporate earnings in 2022, which alone will be a source of decent returns in the equity markets. Lastly, bonds in 2022 have performed poorly, but now with the 10-Year Treasury bond yield nearing 2.50%, perhaps the yield alone is attractive to investors. Certainly, bonds always offer portfolios protection during times drastic market uncertainty and volatility, specifically geopolitical risks and economic anxiety.