First-Quarter 2022 Review and Outlook
Faced with war in Ukraine, soaring energy prices and increasingly hawkish central bankers, nearly all categories of financial investments suffered moderate losses in the first three months of the year. Large-company U.S. stocks declined around 5%, on average, while their small-company counterparts fell slightly more. Non-U.S. equities faced headwinds from a strengthening U.S. currency: the developed-market category declined about 5% while emerging markets, paced by a double-digit swoon in China, dipped somewhat more. Real-estate securities, too, fell around 5%, on average, though resource-based vehicles did better. Commodities were a distinct bright spot, with gold gaining around 6% and oil surging 35%. Bond yields soared: the benchmark 10-year Treasury ended the period at 2.33%, compared to 1.51% at the end of 2021. With widening credit spreads adding insult to injury, all categories of fixed-income investments produced negative returns.
Among U.S. large-company stocks, constituents of the Materials, Energy, Health Care and Utilities sectors posted relatively better returns, while the Industrials, Consumer Cyclicals and Technology groups were among the worst performers; Consumer Staples and Financial names were mixed. While value handily outperformed growth among both large- and small-capitalization stocks, the pattern seemed to be shifting again late in the period.
The first three months of 2022 reminded many of a quip attributed to V.I. Lenin: There are decades where nothing happens; and there are weeks where decades happen. And we sheepishly note that our early-January prognostications contained no mention of either Russia or Ukraine.
We won’t attempt to recap the battlefield and diplomatic whirlwind of the past two months. Suffice to say that although Russian aggression was widely telegraphed, it still came as a shock to most – and Mr. Putin’s not-so-subtle nuclear saber-rattling was a novel treat for all. The most noteworthy surprises from the conflict’s first weeks were Russia’s stunning lack of battlefield success and the unprecedented economic and diplomatic response from a coalition of major nations that represent a preponderance of global economic and military might (though China, India, Brazil, South Africa and key Middle Eastern energy producers were notably absent from that group).
While geopolitics and war dominated the headlines, the COVID pandemic continued to menace economic activity around the globe. The omicron-variant created an unprecedented wave of infections but relatively fewer hospitalizations and deaths. In the U.S., the tide receded in February/March almost as suddenly as it arrived in December/January, but other regions saw persistently high (Europe) or rising (Asia) levels of infection, possibly presaging U.S. conditions of coming months. Importantly, authorities across nearly all regions (with the notable exception of China) decided that widespread immunity and the availability of highly effective vaccines and new antiviral drugs meant restrictions on activity and commerce could largely be removed – a policy shift that had the potential to render the pandemic essentially over from an economic perspective.
The U.S. economy continued to set a heady pace of recovery from the pandemic-induced downturn. Aggregate activity (GDP) expanded at a robust +6.9% annualized pace in the final three months of 2021, though inventory restocking amid easing supply-chain bottlenecks played an outsize role; underlying consumption grew more slowly. First-quarter data indicated growth remained healthy: monthly job gains averaged better than 500,000 and the official unemployment rate of 3.6% stood near its (historically low) pre-pandemic level. Posted job openings exceeded the number of unemployed workers, indicating an exceptionally tight labor market; purchasing-managers surveys signaled solid expansion across most industries. House prices soared: the most recent data indicated year-over-year gains of +19% (though these predated most of a surge in mortgage rates, which reached levels last seen in 2018). Inflation continued to rise and, more worrisome, broadened to many categories beyond used vehicles and COVID-disrupted services; the headline CPI figure accelerated to +7.9% in February – the worst reading since January 1982. Spiking gasoline prices and volatile financial markets weighed on consumer sentiment, which fell to its lowest level since 2011 and was likely a factor in relatively weak consumer spending.
Overseas economic activity was mixed. Reflecting differential regional pandemic situations, Asia outpaced Europe as 2021 drew to a close, while the pattern reversed in the new year. European purchasing-managers and business-sentiment surveys suggested a quickening pace of growth in January/February, though activity slowed anew with the onset of hostilities in Ukraine. Japan and South Korea battled the worst COVID conditions the region has seen, though industrial output was relatively resilient as supply-chain disruptions eased and authorities opted not to re-impose draconian restrictions. China was beset by its ongoing real-estate malaise, falling stock prices and, late in the period, a notable uptick in COVID infections that was met with tight lockdowns of major urban centers; purchasing-managers surveys indicated manufacturing and services activity both contracted in March for the first time in almost two years. Inflation soared across much of the globe, with the OECD 30-country average hitting 7.7% in February – up from less than 2% a year ago and the highest reading in more than 30 years.
The biggest financial-markets story of the quarter was a remarkable shift in monetary policy in response to surging inflation. At its March policy-setting meeting, the U.S. Federal Reserve surprised no one by lifting short-term rates for the first time since late-2018, increasing the target by 0.25% to a range of 0.25% to 0.50%. Much less anticipated was an abrupt change in signaling, indicating the March hike was now seen as the first of seven penciled in for this year, to be followed by four more in 2023; also explicitly mooted for the first time in years was the prospect of hikes of greater than 0.25%. Bond yields surged in response to the changed tone, producing the worst fixed-income returns in decades (10-year U.S. Treasury notes provided a three-month total return of minus 6.8%). Shorter-term yields – like those of two-year Treasurys – rose the most, resulting in “inversion” of certain segments of the yield curve (an anomaly where shorter-term yields are higher than those of longer-maturity issues).
The Russia/Ukraine conflict and ensuing international sanctions created severe turbulence in energy and other commodity markets, as both Russia and Ukraine are major suppliers of various raw materials. Crude oil spiked nearly 65% to above $120 a barrel in early March before falling back on COVID-lockdown/slowing-growth news out of China. North American natural gas prices surged 60% (though they remained below levels seen last October); in Europe the increase briefly exceeded 200% before settling back. Wheat prices rose around 30%. Among the most dramatic action occurred in the nickel market: the price of the important industrial metal briefly soared more than 500% and finished the period up nearly 80%.
Reacting to surging bond yields and the Ukraine crisis, global stocks swooned but then largely recovered. The draw-down reached its nadir (so far?) the second week of March, with the S&P 500 and NASDAQ Composite indices briefly falling 14% and 21%, respectively, from early-January highs. A furious rally beginning in mid-March propelled the indices 11% and 16% higher from the lows before they settled back at quarter-end; notably, both finished above their levels at the onset of fighting in Ukraine. Index-average returns obscured unusually disparate outcomes. Many basic-material, energy, health-care and defense-industry issues recorded double-digit gains: fertilizer-producer Mosaic +69%; energy-major Chevron +39%; pharma heavyweight Abbvie +21%; weapons-maker General Dynamics +17%. Highly valued technology and consumer-oriented business swooned: Facebook-owner Meta -34%; chip-maker Advanced Micro Devices -24%; Home Depot -28%; General Motors -25%. Non-U.S. stock returns were also varied: the (tiny) Russian market imploded before shutting down and the (huge) Chinese one tanked early but then stabilized; a number of resource-heavy markets managed gains, paced by Brazilian stocks surging more than 30% in dollar terms.
The large U.S. companies that make up the S&P 500 Index again posted strong profits, with results reported during the period up +33% from a year ago. Wall Street analysts, seemingly unfazed by war, soaring inflation and surging bond yields, ratcheted higher their expectations of earnings for the remainder of 2022 (18% above 2021) and into 2023 (+9% vs 2022).
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the -4.6% S&P 500 total return?
First Quarter (January - March) 2022
+ Change in Earnings
+ Change in Valuation
= Total Return
So,what changed during the recent quarter to produce the -4.6% S&P 500 total return?
Our read: Rising profits combined with falling prices resulted in a relatively large improvement in valuation; we expect rising bond yields will continue to exert downward pressure on multiples.
While the pandemic continues to lurk, geopolitical upheaval and monetary-policy regime change will be the big stories for investors in the months ahead. Uncertainties abound.
The Ukraine crisis provides a novel and unpredictable source of economic and market disruption. Stiff Ukrainian resistance leading to mounting Russian battlefield setbacks combined with surprisingly potent sanctions might convince Russia to make concessions leading to a near-term settlement. At least equally plausible, a diplomatic solution could remain elusive, with a less intense war becoming a larger version of the “frozen conflicts” that have plagued the region since Russia’s incursions into Georgia in 2008 and Crimea/Eastern Ukraine in 2014. Global stock markets’ rapid recovery in recent weeks suggests investors have come to see the war less as a fearsome “black swan” event and more as a moderate geopolitical and commodity-market headwind. Let’s hope that conclusion doesn’t turn out to be naively complacent.
The conflict’s near-term implications are likely to be more of what we’ve already seen: collapsing Russian and Ukrainian economies with direct spillovers largely limited to the disruptive and inflationary impacts of high and volatile commodity prices. With its greater exposure to energy and other trade with the combatants, Europe will bear the brunt, though all resource-importing industrialized economies will be impacted to varying degrees. Developing nations, particularly in Africa and the Middle East, will likely face food-supply crises. China has (so far?) been reluctant to back Russia to a degree that would expose the world’s second-largest economy to painful “secondary” sanctions. Prognosticators from Wall Street and international development organizations expect the war to shave between 0.5% and 1.0% from global growth in 2022 – a figure that could grow substantially were Beijing to court “western” wrath by becoming more directly supportive of its friends in Moscow.
Longer-term repercussions could be sizable – and likely mostly negative. These include further impetus toward de-globalization and the possible emergence of trading blocs of “like-minded” nations; a growing focus on economic resiliency at the expense of efficiency; rising defense outlays, budget deficits and, eventually, taxes to pay for it all; heightened urgency around energy security, possibly impeding the transition to non-fossil-fuel sources; a gradually diminishing role for the U.S. dollar in the global financial system, as China and others seek to reduce their vulnerability to the most punitive sanctions placed on Russia. Russia’s newly burnished pariah status and wracked economy may force it into a near-client-state relationship with China, forming an autocratic axis increasingly bound by a common desire to stand up to a more united “west” that already includes Japan and will attempt to recruit the likes of India and Vietnam. On balance these trends, some already discernible in the decade-plus since the Global Financial Crisis, seem likely to act as brakes on global growth and/or corporate profitability in the years ahead.
While war remains on the front burner, investors will nervously eye inflation statistics and the world’s central banks. It’s been more than a generation since the Federal Reserve had to deal with an overheated economy and soaring inflation; its officials have spent the past dozen years propping up lackluster growth and fighting deflationary forces. Now the Fed is forced to combat rising prices without stifling growth – always a delicate balancing act – in the face of a major geopolitical crisis featuring unpredictable economic fallout. The recent partial inversion of the Treasury yield curve – historically a reliable red flag – has rightly raised eyebrows. And their unusually abrupt change of tone over the past two months suggests Fed officials (joining many investors) worry they waited too long to act.
We nevertheless see reasons for optimism. Much of the current burst of inflation stems from highly unusual pandemic-related supply disruptions and demand distortions that are already resolving – though war-induced commodity-price spikes and supply-chain kinks will complicate that process. What central bankers fear most is inflation becoming “embedded” in consumer and business psychology, such that surging prices are expected to become a persistent fact of life. To date there is scant evidence this is happening. Consumers indicate they believe inflation over the next five years will be meaningful below the current rate. Likewise, we see tentative signs the job market is beginning to ease: plateauing vacancies and resignations; growing ranks of workers re-entering the market; a decreasing percentage of employers expecting to raise wages in coming months. Meanwhile, strong consumer finances and substantial pent-up investment demand mean the U.S. economy enjoyed substantial momentum heading into the tightening cycle.
We glimpse other glass-half-full developments in recent and expected market shifts. Most obvious is that as bond yields rise, safe, high-quality fixed-income securities become more viable investments – enhancing both the expected return and return/risk profile of balanced portfolios. Meanwhile, if Wall Street analysts are not deluding themselves (possibly a big if), ongoing profit growth will continue to support stock-market valuation – which is already notably lower than at extreme points of the past several years. Finally, the combination of rising bond yields and slowing growth that seems to be in store will likely engender periodic “recession scares” and bouts of market volatility, providing opportunities to add selectively to stock holdings at more attractive (lower) prices.
We don’t feel far out on a limb suggesting the combination of a major European war and central banks aggressively raising interest rates against a backdrop of decelerating growth has raised the level of risk in global markets. Higher bond yields, lower stock valuations and (we would add) muted investor sentiment are important salutary offsets. But we would be hard-pressed to argue that the investment outlook is just 5% less bright or only 5% more uncertain than it was at the end of 2021 – yet that is the measure of stock-market declines from January’s all-time highs. Accordingly, we think the path ahead is one to tread carefully, with cash and “near-cash” short-term bonds playing an expanded role in balanced portfolios.
We encourage you to call or email a member of the Oarsman team any time to discuss our management of your investment portfolio. And please enjoy spring – if it ever arrives!