The first quarter of 2022 was a challenging start to the New Year for investors. After falling into correction territory, the S&P 500 cut some of its losses late in the quarter to end the period down 4.6%. This marked the first time the index experienced a negative quarter since Q1 of 2020.
Investors Wary on Inflation, War
Concerns over high inflation and future interest rate hikes weighed on stock market returns. Year-over-year inflation rose to its highest reading since 1982 as consumer spending remained strong and supply chain disruptions continued. With the unemployment rate decreasing to 3.6% and year-over-year growth in average hourly earnings exceeding 5% for the last few months, the Fed adopted a more hawkish tone toward monetary policy. This includes a plan to shrink its $9 trillion balance sheet and raise interest rates for the first time since 2018.
The Fed started raising short-term interest rates, and further rate hikes are highly anticipated throughout the remainder of the year. Many believe the federal funds rate will end the year above 2%. Since inflation is shaping up to be a global phenomenon, interest rate hikes were not limited to the United States. The Bank of England has raised interest rates back to their pre-pandemic levels, and Russian interest rates skyrocketed in an attempt to stabilize the deteriorating ruble. The European Central Bank has not yet raised rates, but there is increased speculation that this will have to happen soon to mitigate inflation.
Stock market volatility increased with the Russian invasion of Ukraine and concerns over the impact it could have on the global economy. Crude oil spiked to a high of $130 per barrel during the period. Natural gas, wheat, and corn were among other commodities that saw prices surge because of actual or anticipated reduction in supply from the conflict.
The rise in oil and natural gas prices boosted energy stocks ahead of all other sectors, as the S&P Energy Select Sector Benchmark gained 39% in the first quarter. Strong results from energy stocks were also a catalyst for the outperformance of value stocks this quarter since value tends to have a sector tilt towards energy.
Low volatility stocks also held up well during the quarter, as is usually the case during times of stress in the market. Growth stocks underperformed, especially unprofitable technology stocks, because of the prospect of more aggressive interest rate hikes. This can have an outsized negative impact on future cash flows of “longer duration” assets.
International stocks were slightly worse off than domestic stocks, as countries in Europe have closer trading relationships with Russia and Ukraine. Russian crude oil exports had made up 8% of all imported oil in the United States, whereas countries in Europe import roughly half of their oil from Russia. Reliance on Russian and Ukrainian agricultural goods is also much stronger in the Eurozone.
Emerging market stocks fared poorly in the first quarter as China reinstated lockdowns from rising COVID cases in several cities. The Russian stock market was crushed during the onset of war and even had trading halted for several weeks. Fortunately, most broad emerging market funds tended to have limited exposure to Russian stocks.
Examining the Yield Curve
Treasury bond rates increased substantially during the quarter, but the yield curve also flattened. The yield curve illustrates the interest rates on a given date for similar debt at various maturities. At the end of 2021, the yield curve was upward sloping with longer dated maturities trading at higher yields than maturities that were shorter. Inflation expectations helped shift the yield curve higher at all maturities, but shorter-dated maturities saw an added boost as the Fed looks to raise short-term lending rates.
An important section of the yield curve monitored by economists is the spread between 10-year and 2-year Treasury bond yields. While the ten-year began the period 0.8% higher than the two-year, the ten-year ended the quarter only slightly above the two-year at rates of 2.35% and 2.31% respectively. In fact, the two-year yield did briefly exceed the ten-year yield during the period.
This yield curve “inversion” caused fear among investors since the last eight yield curve inversions in the U.S. were followed by recessions. However, this occurrence should be taken with a grain of salt despite the strong historical relationship with economic downturns. First, the relationship between yield curve inversions and recessions is not as strong in other countries, which suggests the relationship in the U.S. may be somewhat coincidental. Also, even if the relationship does hold, recessions normally occurred 18 months after an inversion first occurred, during which stock market gains continued. Finally, a recession does not always indicate a bear market, as the S&P 500 experience only modest losses during the recessions in the early 1980s and early 1990s.
Nevertheless, rising rates across the yield curve resulted in poor performance for bonds this quarter. The Bloomberg Aggregate Bond Index fell by nearly 6%, worse than the stock market’s decline. Anticipation of ongoing rate hikes and inflationary pressures will likely challenge bond returns going forward. While some may assume inflation-protected securities provide adequate protection against inflation, TIPS lost 3.6% in the first quarter. This is better than the overall bond market, but a Pyrrhic victory given the negative return.
Strong Quarter for Alternatives
Despite a poor quarter for stocks and bonds, our preferred alternative strategies delivered very strong results this quarter. The funds we use for managed futures and style premia both generated double-digit returns for the quarter, while alternative lending and reinsurance also saw modest gains. The multi-strategy fund was the only strategy that was negative this quarter, but still outperformed the S&P 500 and overall bond market.
Inflation, interest rate hikes, and war were a few of the most notable factors driving volatility in the first quarter. This volatility has so far appeared directionless as investors continue to monitor and digest an influx of new information. For example, the S&P 500 was consistently negative in the week leading up to the war in Ukraine, yet it jumped nearly 4% during the two days immediately after the invasion began. Market fluctuations were wild intra-day during the latest Fed meeting to raise interest rates, but the movements had no directional trend.
Developments regarding the war and inflation will likely continue to cause volatility in the near term, but that does not suggest a bear market is imminent. There is certainly plenty to worry about, but fundamentals for stocks are showing relatively strong signals with earnings growth expanding at a rapid pace. Stock buybacks, which tend to occur when management believes the stock is undervalued, reached a record high in 2021. So, while the market faces various headwinds that threaten returns, there have been ample supports that have so far kept downside fairly limited.
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