2022 arrived on a tailwind of strong market performance and economic growth, carrying with it the hope of new beginnings as we cautiously began to emerge from the pandemic. But financial markets were quickly roiling again amid accelerating inflation, fears of rising interest rates, and escalating tensions on the Russia-Ukraine border. After prospects of a diplomatic solution were dashed, stocks slumped. As the hostilities intensified, investors began assessing the global economic impact of the invasion and the reverberations of the sanctions that followed. Stock market weakness continued into February as investors worried that the Fed’s slow response to address high inflation would lead to more rate hikes than initially anticipated, a dreaded sign of aggressive monetary policies. Entering the last month of Q1, the atmosphere was volatile indeed.

But amid all of the uncertainty, there were still wins to be found. By mid-March, stocks staged a strong turnaround that reversed much of the quarter-to-date declines as investors welcomed clarity on monetary policy following the Federal Open Market Committee’s March meeting and encouraging economic data. Corporate profits kept the wind in their sails from 2021, with 76% of the 95% of S&P 500 constituent companies reporting a positive earnings surprise in Q421. Expectations for Q122 data are to moderate yet continue in a positive direction. [1]

 

ECONOMIC CONDITIONS: U.S. – Economic Recovery Continues

GDP: Expectations for economic expansion in Q1 were already modest due to the lingering effects of Omicron, then Russia’s invasion of Ukraine further dampened the outlook. The Federal Reserve Bank of Atlanta, which attempts to track GDP growth in real-time, reported that its “GDP Now” forecasting model lowered its nearly 2.0% Q1 GDP pre-invasion annualized growth rate estimate to 1.3% as of March 31, 2022. [4]

UNEMPLOYMENT: The solid economic performance in the fourth quarter helped drive the unemployment rate down from 4.8% in September to 3.9% in December. This favorable trend carried over into the first quarter of 2022 with the unemployment rate falling further to 3.8% in February. [3]

HOUSING: The most popular U.S. home loan – the 30-year fixed mortgage – rose to a three-year high of 4.9% by the first quarter’s end according to April data from the Mortgage Bankers Association (MBA).

Redfin agents in San Francisco, Los Angeles, Washington D.C., Boston, and Seattle reported a drop in requests for homebuying help at the start of 2022 as compared with last year. But even with possible early signs of a housing market cooldown, activity remains hot for sellers. The average home in Los Angeles, for example, is sold for 5% over its asking price and the majority of listings sell within a week.

INTERNATIONAL: War Stalls Recovery

The economic repercussions of Russia’s invasion of Ukraine are widespread. Commodities prices – from oil and agricultural products to natural gas and base metals – will most likely stay elevated for the foreseeable future. This sustained elevation may be due to the combination of sanctions, the destruction of infrastructure, and supply chain disruption as land- and sea-based trade routes have become impeded or completely closed down.

While the measure of the invasion’s full economic impact remains fluid and imprecise, according to the Economist Intelligence Unit (EIU), a British-based economic research and analytics group, economic growth in Europe may slow down by nearly 50% from a pre-war estimate of 3.9% to about 2.0%. The impact on eurozone countries may be less severe, with estimates revised from 4.0% to 3.7%. EIU also projects that global growth will be shaved by 0.5 percentage points, from 3.9% to 3.4%. [8]

The United Kingdom is facing a similar outlook. The British Chamber of Commerce downgraded its forecast for economic growth in 2022, reducing its initial 4.2% growth projection to 3.6% in the wake of the Russian invasion. [9]

The Japanese economy saw a steep slowdown in the first quarter due to a surge in Omicron infections. A Reuters poll of analysts lowered their median Q1 GDP annualized growth rate from 4.5% to 0.4%. Japan’s economy may remain under pressure as a declining yen has exacerbated rising energy and commodity prices. [10]

Finally, China set its 2022 growth rate target at 5.5%, the lowest in more than 25 years. Even this modest goal may be challenging to reach amid struggles to manage a surge in COVID-19 infections that have led to shutdowns of cities and factories and regulatory pressures in its property and technology sectors. [11]

 

EQUITIES: Correcting

U.S. EQUITIES: At its worst point in the quarter, the S&P 500 Index was down more than 14% before staging a rebound in March, finishing Q1 at -4.6%. Internally, Value stocks vastly outperformed Growth stocks after years of underperformance. The Morningstar U.S. Large Value Index outperformed the U.S. Large Growth Index by more than 14 percentage points at quarter end. The growth-heavy Nasdaq Composite started the year on a rough note, ending down -9.10%. Small cap firms managed to outperform on the quarter as the Russell 2000 Index was down only -2.4%. [15]

DEVELOPED INTERNATIONAL EQUITIES: Developed market equities recovered some of their losses to end March up about 3% but were still down 5% year-to-date (YTD). The MSCI EAFE index, which tracks developed-economy stock market performance in Asia and Europe, lost -5.13% during the quarter.

EMERGING MARKETS: Emerging market (EM) equities were firmly down in Q1 as geopolitical tensions took center stage following Russia’s launch of a full-scale invasion of Ukraine. The U.S. and its Western allies responded with a raft of sanctions. Commodity prices moved higher in response to the war, raising concerns over the impact on inflation, policy tightening and the outlook for growth.

Egypt, a major wheat importer, was the weakest market in the MSCI EM index due in part to a 14% currency devaluation relative to the U.S. dollar. China lagged by a wide margin as daily new cases of COVID-19 spiked and lockdowns were imposed in several cities, including Shanghai. Regulatory concerns relating to U.S.-listed Chinese stocks contributed to market volatility. Poland, Hungary and South Korea also underperformed. At quarter end, the FTSE Emerging Market index dropped -5.24%.

 

 

FIXED INCOME: Rates Moving

U.S. FIXED INCOME: After peaking at 2.5% in Q1, the 10-year U.S. Treasury yield ended around 2.3% following the release of Fed meeting notes indicating a more aggressive rate-hiking trajectory than previously signaled. Yield curves sharply bear-flattened, with the yield on the U.S. 2-Year Treasury briefly surpassing those on the 10-Year benchmark in late March amid growing fears of a policy misstep.

DEVELOPED INTERNATIONAL FIXED INCOME: Global bonds continued to sell off in March, extending their Q1 losses. Chinese governments fared far better than their peers during the quarter. Short-dated U.K. and U.S. inflation-linked bonds ended flat or modestly higher in Q1, outperforming the sharp declines in their longer-dated counterparts. Corporate bonds fell even more, particularly in EM, where investment- grade and high-yield credit posted double-digit losses for the quarter.

 

 

FIXED INCOME: Rates Moving

U.S. FIXED INCOME: After peaking at 2.5% in Q1, the 10-year U.S. Treasury yield ended around 2.3% following the release of Fed meeting notes indicating a more aggressive rate-hiking trajectory than previously signaled. Yield curves sharply bear-flattened, with the yield on the U.S. 2-Year Treasury briefly surpassing those on the 10-Year benchmark in late March amid growing fears of a policy misstep.

DEVELOPED INTERNATIONAL FIXED INCOME: Global bonds continued to sell off in March, extending their Q1 losses. Chinese governments fared far better than their peers during the quarter. Short-dated U.K. and U.S. inflation-linked bonds ended flat or modestly higher in Q1, outperforming the sharp declines in their longer-dated counterparts. Corporate bonds fell even more, particularly in EM, where investment- grade and high-yield credit posted double-digit losses for the quarter.

 

DPWM OUTLOOK: Corrections Can Equal Opportunity

Entering 2022, investors were readying themselves for slow but solid economic growth and a leveling-off yet still positively-trending stock market. There’s no denying that much of the volatility we are seeing now is due to the markets’ reactions to Q1’s persistent inflation. It took turning the page to the new year for investors to fully face the reality of a more aggressive Fed, a slowdown in corporate earnings growth, and a devaluing of high-growth companies whose earnings may not be seen until the distant future.

In one respect, the market correction (defined as a decline of 10-20% from recent market highs) triggered in the first quarter shouldn’t have come as a surprise to experienced investors. There have been 27 such declines since World War II, with the last one occurring in 2018. By historical standards, a correction was overdue. Past corrections averaged a decline of 13.7% and lasted for about four months (not including corrections that turn into bear markets, i.e., a decline of 20% or more).13

Nevertheless, historical performance is only a guide, not a guarantee of the future. So, as investors look forward, they may see three significant headwinds for the market:

• Inflation: While a tighter monetary policy is the Fed’s primary tool in fighting inflation, it’s a clunky one: higher interest rates take time to cycle through the economic Also, an aggressive Fed does little to solve the current supply chain problems that are significantly contributing to our rising prices.
• Higher interest rates: While higher rates may be effective for lowering inflation for the long-term, it can come at a short-term cost to investors. Higher interest rates – along with any shrinking of the Fed’s balance sheet – may reduce liquidity in the markets which can put downward pressure on stocks.
• Evolving geopolitical issues: We’ve seen markets unsettled by war in the past. They tend to regain their balance in a relatively short period of time. A peaceful resolution to the Ukraine crisis would be met would deep relief by investors, potentially allowing markets to rally and return to focusing on the economic fundamentals that promote a growing economy. But the conflict is unpredictable, and its global economic ramifications are wide and growing. The market’s near- term prospects are seemingly intertwined with the unfolding events in Eastern Europe.

Any significant market trend – be it up or down – can be a catalyst for opportunity elsewhere. Within our models, we took advantage of higher short-term rates and the bond sell-off by adding short- term Treasuries to the portfolios, thus adding protection against a market sell-off at higher yields.

Given the macro outlook of slowing nominal GDP growth and rising interest rates, U.S. equities in general face increasing headwinds going forward. It could be particularly challenging given a forward Price to Earnings (P/E) ratio on the S&P 500 that is still roughly 15% above its 25-year average. However, value stocks carry a P/E ratio which is much lower than normal when compared to growth stocks. This could point to better returns for value going forward, particularly in a rising rate environment (see chart below). In order to take advantage of these changing dynamics, we increased our U.S. Large Cap Value exposure during the quarter.

Lastly, international equities also look very cheap relative to U.S. stocks and could fare better if the Ukraine conflict is resolved. If – as predicted – U.S. economic growth slows relative to the rest of the world, DPWM’s positioning overseas should benefit from the continuing rebound in earnings and imminent economic recovery abroad.

 

1. Factset.com, February 25, 2022
2. BEA.gov, March 30, 2022
3. Statista, March 7, 2022
4. AtlantaFed.org, April 5, 2022
5. CNBC, March 6, 2022
6. Bureau of Labor Statistics, March 15, 2022
7. WSJ.com, March 17, 2022
8. Economist Intelligence Update, March 3, 2022
9. British Chambers of Commerce, March 4, 2022
10. Reuters.com, February 27, 2022
11. WSJ.com, March 4, 2022
12. MSCI.com, April 5, 2022
13. CNBC, February 27, 2022