by William Henderson, Chief Investment Officer
In much the same way we have seen violent selloffs precipitated by a risk-off trade, last week we saw a massive rally in equities and a related risk-on trade across all equity market sectors. The major market indexes posted their largest weekly gains since November 2020. The Dow Jones Industrial Average rose +5.5%, the S&P 500 Index rose +6.2% and the NASDAQ jumped higher by +8.2%. We have often spoken about the pitfalls of market timing and risks of missing the “big-move” days, well last week was a big-move week that rewarded investors that stayed the course and remained committed to their long-term investment plan. Year-to-date returns, while still in negative territory for the year, gained back a lot of their losses thus far in 2022. Year-to-date, the Dow Jones Industrial Average is down -3.9%, the S&P 500 Index is down -6.1% and the NASDAQ, gaining back over half of its year-to-date loss is now down -11.1% in 2022.  

In potentially the least anticipated move of the year, the FOMC (Federal Open Market Committee) raised interest rates by a quarter of a point for the first time since 2018. Further, Fed Chair, Jay Powell, projected a clear path for 2022 with as many as six additional rate hikes bringing short-term rates to 1.75-2.00% by year-end 2022. Amid this news and continued high inflation readings, prices of government bonds fell, sending yields on U.S. Treasury Bonds higher for the second week in a row. The yield on the benchmark 10-Year U.S. Treasury Bond rose to 2.14% on Friday – the highest level in three years and up sharply from 1.73% just two weeks ago when the Ukraine / Russia war forced a temporary flight to quality amid major global geopolitical uncertainty. (See the chart below from the Federal Reserve Bank of St. Louis showing the 10-Year U.S. Treasury over the past three years.) 

Despite the continued geopolitical uncertainty, inflation in the U.S. is clearly the dominant story and the absolute focus of the Fed. Chairman Powell is intent on raising rates this year to combat the strongest inflation data in 40 years. Price pressures exist on many fronts beyond those impacted by the pandemic and the resultant supply-chain crunch. Higher prices are being seen in autos, food, housing, rents, and many critical commodities such as oil and nickel, which are further pressured due to economic sanctions on Russia. During Powell’s press conference, after the FOMC meeting, he mentioned that Fed policymakers are now projecting inflation (as measured by core Personal Consumption Expenditure or PCE) to reach 4.1%, up from their previous projection of 2.7%. Policymakers are clearly acknowledging that inflation will remain elevated for an extended period, and they are intent on gradually raising rates to combat inflated prices. While interest rate hikes are on the horizon for 2022 and into 2023, it does not mean that equities will perform poorly.  In fact, over previous rate hiking cycles, equities markets have performed quite well. (See the chart below from FactSet and Edward Jones showing previous rate hike cycles and returns of the S&P 500 Index.) 

When you review the fundamentals of the U.S. economy and by extension the equity markets, the foundation for strength in both continues. In fact, most major components of the economy: housing, bank health, corporate strength, consumer health and labor remain solid. Chairman Powell pointed to the extraordinarily strong economy and tight labor conditions as additional reasons why they were raising rates at this time. Pointedly, unemployment is at a near record low 3.8%, while job openings continue to exceed the number of unemployed leaving a very tight labor market as a result. (See the chart below from FactSet showing the gap between job openings and the unemployed). The widening gap shown is evidence of tight labor conditions. 

It is difficult, if not impossible, to project market returns weeks ahead, let alone months and years. The geopolitical concerns remain economic headwinds specifically the Russia / Ukraine war and price pressures in critical commodities like oil and rare earth metals and, as we have mentioned multiple times, markets hate uncertainty. The road ahead will be choppy and uncertain, and the Fed is attempting the oft impossible “economic soft-landing” of raising interest rates to stifle inflation, but not bringing the economy to a halt. As witnessed by last week’s stellar rally in equity markets, hiding on the sidelines is not a winning strategy. 

by William Henderson, Chief Investment Officer
All major market indexes fell last week adding to an already poor start of the year in equity markets. Even a wild upward rally on Wednesday was not enough to thwart negative returns across the board. The Dow Jones Industrial Average fell -2.0%, the S&P 500 Index fell -2.9% and the NASDAQ lost -3.5%. Year-to-date returns have stayed well into negative territory for all three major market indexes. Year-to-date, the Dow Jones Industrial Average is down -8.9%, the S&P 500 Index is down -11.5% and the NASDAQ has moved into technical “Bear Market” territory being down -17.8%. The Russia / Ukraine war has taken a triple toll on the markets: pushing oil higher, further impacting overall inflation, and finally impacting U.S. Consumer Sentiment. Inflation fears and this week’s FOMC (Federal Open Market Committee) meeting, where markets are expecting the Fed to raise interest rates for the first time in three years, negatively impacted U.S. Treasury bonds leaving us with a very volatile week in fixed income markets. After finishing the previous week at 1.73%, the yield on the 10-Year U.S. Treasury bond jumped last week by 27 basis points to close at 2.00%. (See the chart below from the Federal Reserve Bank of St. Louis).  

The yield on the 10-Year U.S. Treasury is now well off the dramatic all-time low of 0.50% hit during the peak of the COVID-19 outbreak and is working its way back to pre-pandemic levels. However, even as market participants are seeing higher yields, remember that if fear and uncertainty exist investors will need the risk management provided by fixed income securities. 

As mentioned, inflation, as measured by the U.S. CPI (Consumer Price Index), for February 2022 came in at 7.9% versus 2021, a 40-year high. All sectors, led by higher energy prices, showed increases including food and rent. See the chart below from FactSet showing oil prices (WTI Crude – left scale) and Inflation (U.S. CPI – right scale) and their close correlation. 

Critically, understand that the inflation data is backward looking information from February 2022 and therefore has not even considered the recent run up in oil prices during the month of March. This gives us a lot more confidence around the Fed’s plan for higher interest rates soon. 

Another data point that has us worried was last week’s release of the March preliminary University of Michigan Consumer Sentiment Index (previously called Consumer Confidence Index), which came in lower than expected at 59.7, versus a Bloomberg estimate of 61.0. At that level, the measure of consumer sentiment is the lowest since 2011 and well off the highs hit at the beginning of 2021 when COVID-19 was waning, and the geopolitical climate was a lot calmer. Throw in significantly higher oil prices and you get a worried consumer. (See the chart below from YCharts and Valley National Financial Advisors showing U.S. Consumer Sentiment since April 2021). 

We always talk about the efficiency of the markets, and we believe this to be the case today as always. Last week’s wild ride in the markets saw a 650-point (+2%) swing in the Dow Jones Industrial Average on Tuesday based on rumors of positive comments from Russian leader Vladmir Putin and hints of a ceasefire. This upward move was quickly reversed when peace talks fell apart and instead Russian invasions efforts into Ukraine intensified. As we write this report, ceasefire whispers are again underway, and markets are rallying. The international pressure on Russia and by decree on Vladmir Putin are enormous. Aside from blocking monetary transactions on SWIFT, an oil embargo by the west and severe sanctions elsewhere, the U.S. Department of Justice announced an intense “hunt” for assets held in the U.S. belonging to Russian Oligarchs. Putin was desperate enough to ask China for military and economic aid for its Ukraine war. This action was met swiftly with rebuke from Washington strongly advising China against any assistance whatsoever with Russia. In fact, this week, Washington officials are scheduled to meet with Chinese counterparts in Rome to discuss the war.  

It is difficult to see any outcome for Russia that ends well. The only plausible endgame is for a negotiated solution between Ukraine and Russia that gives Putin something yet allows Ukraine to remain and independent state. Unfortunately, if the war drags on, uncertainty and fear will persist, and the markets will react accordingly. Beyond the humanitarian impact the war is having, prices of such commodities as oil, natural gas and palladium are skyrocketing and inflation is the result which further impacts consumers and eventually economic growth. Expect inflation to continue for longer but the Fed will be on the move this week and their new objective will be to combat inflation. This week’s FOMC meeting will be important for reasons beyond the expected 25 basis point rate hike. The markets will be watching for language around the pace of future hikes and the scope of balance sheet reduction. This may add some calm and clarity to the markets, but it could be overshadowed by any breakdown in peace talks or unwelcomed involvement from China.