Q1 2022 Investment Review and Outlook
A lot has happened the last three months! One of our biggest challenges is to boil it down into a succinct presentation that provides you enough information to have an understanding of how things happening in the world are impacting your investments but also to give you perspective on what it could mean for the future. Here is a look at how markets performed in the first quarter of 2022, a brief overview of the issues moving markets and some historical perspective to keep things in check.
It was a rough first quarter across the board, with stocks, bonds, U.S., international and emerging markets all hurt by rising interest rates, inflation, and the war in Ukraine. Commodities including gold were the exception as both posted positive returns, benefiting from commodity supply concerns and global uncertainty.
Among the major global stock markets, the S&P 500 was a relative outperformer, dropping 4.6%. While growth stocks, which are heavily represented in the NASDAQ index, performed the worst . The relatively mild declines for the full quarter masked the intra-quarter volatility, where peak-to-trough declines were much larger.
Unusually, the damage was worse in the U.S. core bond market than the U.S. stock market. The benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) fell 5.9% for the quarter. This was the second-worst quarter for the bond index since Q1 of 1980. YTD both the stocks and bonds have negative returns. If this holds, for the rest of the year, then it would be the first time in the last 35 years that both were negative in a full calendar year.
Global new cases have fallen sharply from Omicron’s peak, but there has been a recent uptick of new cases in China and other Asian countries as well as in Europe. The U.S. may soon face a similar increase. But over time, with continued rising immunity rates, vaccines, medical advancements, and social and business adaptation, the economic damage and disruption should continue to recede. If this holds true then it should support both economic growth through consumer and business spending and also mitigate some of the inflationary pressures experienced last year that were caused by shut-downs, surge in demand for consumer goods (autos, etc.) and lack of workers.
Russian Invasion of Ukraine
Just as the economy began to move show signs of moving on from COVID. Russia invaded Ukraine. The war in Ukraine has caused massive human suffering and our hearts are with the people of Ukraine. Looking at it from an economic and investment perspective the war has caused a major supply-shock in food and energy that has pushed inflation higher, negatively impacted consumer spending and likewise leading to slower global economic growth.
Slowing economic growth is not the only issues sprung from the war in Ukraine. Governments and central bank policy responses to the war have created additional risks and uncertainty for the economy and markets.
The worlds dependency on Russian oil and natural gas has been well reported and you can see the price at the pump when we fill up our gas tanks. What is less publicized is just how critical Russia and Ukraine are in the production of agricultural commodities that impact global food supply and global food prices. Russia is the largest exporter of wheat in the world while Ukraine ranks 5th and most of those wheat exports are to Europe, Africa and Asia. Russia and it's neighboring puppet state Belarus, which is also under sanctions provide close to 40% of the worlds potash which is used by farmers around the world to fertilize their crops and maximize their harvest. To put pressure on Russia most of the western world has banded together to boycott purchasing Russian goods which in turn has led to a surge in food prices throughout the world. In March the global food price index was up 13% . Rising prices on necessary expenses like food take away from the discretionary income people have to spend on other goods and services that grow the economy.
The same is true for rising fuel prices. Russia is a major global supplier of oil and natural gas. Europe imports approx. 25% of its oil and over 40% of the gas used to heat homes and power industries from Russia. In retaliation to sanctions, Russia has threatened to shut off the taps and stop supplying oil and gas to Europe which has led EU officials and others countries to worry about energy security. Europe is acting quickly to mitigate the impact of rising energy prices by diversifying their gas supply ahead of next winter. Part of this is accelerating the transition to renewable energy but also to increase domestic storage of traditional fossil fuels purchased from the US, Qatar, Saudi Arabia and elsewhere.
While higher energy prices could slow the European economy, they should have a smaller impact on the U.S. For two reasons: First the energy share of household spending has been declining for years and, by February of 2022, accounted for just over 4% of U.S. consumer spending. In addition, the growth in U.S. shale oil in recent years means that the U.S. is now essentially self-sufficient in oil. Unlike in the 1970s, when oil prices spiked, American consumers got poorer, and foreign oil producers got richer. Today, when oil prices spike, U.S. producers get richer, allowing purchasing power to stay in the U.S. This diminished vulnerability to an oil shock, should help to stabilize the economy.
Finally, it's worth paying attention to what the political consequences might be around the world specifically in poorer countries in Europe and Africa. If the war in Ukraine is prolonged and the food and energy shortage persists into the winter then there could be a lot of cold, hungry and people who point the blame and look for solutions from their government which can often incite political turmoil.
Inflation continue to rise
What is front and center in the US are inflation concerns. Inflation readings in the U.S. have gotten worse over the past three months and in March inflation rose to 8.5% from a year prior. Some of the inflation we are experiencing in consumer goods should fade as we move on from the pandemic and consumers shift their spending back to services and the supply chain issues are cured by fewer shut downs and more workers.
From a historical context, it's been a while, but we have seen inflation before. Previous surges in inflation were associated with unique events some of which lasted for years and coincided with weaker economic and market gains especially when inflation exceeds 4% (see below). The 70's were a decade marked by high inflation. Since then more active monetary policies have been in place to help contain it. The big debate among economist now is whether the Federal Reserve can effectively use those policies to bring prices down in the near term without triggering a broader economic recession.
There have been 15 recessions in the last 100 years. Recency bias may skew our perspective on recessions because the last 2 recessions in the US, the financial crisis in '08 and '09, and the very short lived recession due to COVID in 2020, were the worst since the great depression. The fact of the matter is most recessions are not that bad.
Recession periods on average last just over a year and then give way to expansionary periods that typically last much longer, about 5 years on average. For investors, the important thing is to not try and time the recession but to own the right kind of investments if a recession does start.
Bear and Bull Market Cycles
Like the economy investment markets regularly go through cycles. The good times are referred to as bull markets and the bad times bear markets. Bear markets are declared when prices fall 20% from their recent high. Like recessions bear markets happen frequently and tend to be much shorter than bull markets. Bear markets can be scary, on average an S&P 500 bear market has seen investments fall 38%. However, those who hold steady tend to be rewarded by average bull market returns of +208%. As you can see stock market investors over the last 30 year have been rewarded handsomely with two of the longest and most fruitful bull market periods in history.
The final point to make on the current market environment is that it is an election year. Over the summer campaign rhetoric will kick into high gear with lots of contradictions by both sides on the state of the economy and lots of over blown fear mongering. Campaigns stoke investor emotions and the prospect of change injects uncertainty about what future policy might look like both can have positive and negative impact on investment markets.
Specific to 2022, President Biden is entering his second year of his presidential cycle. Historically the second year of a presidential cycle have been the most volatile for stocks with average declines of 19% followed by rebounds of over the following year of +30% (source: Strategas).
We expect the combination of economic challenges and political uncertainty to lead to continued volatility in markets over the coming months. With history as our guide we see that the pain is typically short lived and believe that with the right attitude and a disciplined investment approach there will be long-term opportunities.
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