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  • First Quarter 2022 Commentary

    Inflation, Geopolitics and Rising Rates Weigh on Markets in the First Quarter

    4/14/2022

    2022 First Quarter Recap

    After a historically calm 2021, volatility returned in the first quarter of 2022, as inflation surged to 40-year highs, the Federal Reserve promised to raise interest rates faster than previously thought, and Russia surprised the world with a full-scale military invasion of Ukraine, marking the first major military conflict in Europe in decades. Those factors fueled a rise in volatility and pushed stocks lower in the first three months of the year.

    Broad market volatility began to pick up during the first few days of 2022 as inflation readings hit multi-decade highs, confirming that price pressures were still accelerating. That prompted multiple Federal Reserve officials to signal that interest rates will rise faster than markets had previously thought, including a possible rate hike in March. The prospect of sooner-than-expected interest rate hikes weighed on the sectors with the highest valuations, specifically growth-oriented technology stocks. The steep declines in the tech sector exacerbated market volatility in January. Additionally, while the fourth-quarter earnings season was solid, there were several large, widely held technology companies that posted disappointing results or forecasts, which also contributed to general market volatility. Finally, in late January at the FOMC meeting, Fed Chair Powell clearly signaled that the Fed would begin raising rates at the next meeting (in March) confirming to investors that interest rates were going to rise more quickly than assumed just a few months prior. The S&P 500 ended January with the worst monthly return since March 2020 (the onset of the pandemic).

    Volatility remained elevated in February with the market’s primary concern shifting from monetary policy to geopolitics as Russia amassed troops on the Ukrainian border, prompting warnings from the United States and other Western countries of an imminent invasion. The rising threat of a major military conflict in Europe for the first time in decades further weighed on stocks in early February. That additional uncertainty combined with high inflation readings and continued warnings from Fed officials about future interest rate increases kept markets volatile throughout most of the month. The Russian invasion of the Ukraine on February 24th, send commodity prices such as oil, wheat, corn, and natural gas surging as commodity producers and end users feared production disruptions and reduced supply. Markets dropped in response to the invasion, because of rising geopolitical concerns and the realization that higher commodity prices would exacerbate existing inflation pressures, and in turn, possibly pressure corporate earnings and consumer spending. Geopolitical uncertainty combined with lingering inflation concerns and anxiety over the pace of Fed rate hikes weighed on stocks again in February, and the S&P 500 declined for a second straight month.

    Markets remained volatile in early March, as hopes for a relatively quick ceasefire in Ukraine faded and commodity prices stayed elevated. Shortly after Russia’s invasion, the developed world united in a never-before-seen way against Russia, imposing crushing economic sanctions on the Russian economy.

    But while that demonstrated important unity against Russian aggression, it became clear that the sanctions would also have a negative impact on Western economies, especially in the EU, and that raised concerns about a global economic slowdown. However, stocks did mount a strong rebound in late March thanks to incrementally positive geopolitical and monetary policy news. First, the Ukrainian resistance stalled the Russian advance, and while the situation devolved into an intense humanitarian tragedy in Ukraine, fears of the conflict extending beyond Ukraine’s borders faded over the course of the month. On March 16th, the Federal Reserve raised interest rates by 25 basis points, the first-rate hike in over three years. This highly anticipated rate hike provided a spark for a “relief rally” in stocks that produced a positive monthly return for the S&P 500 and carried the major indices to multi-week highs by the end of the quarter.
    In sum, the first quarter of 2022 was the most volatile quarter for markets since the depths of the pandemic in 2020, as numerous threats to economic growth emerged. As we start the second quarter, investors will need to see incrementally positive progress across geopolitics, monetary policy expectations, and the outlook for inflation if the late March rally is to continue.

    First Quarter Performance Review

    Equity markets posted negative returns for the first quarter of 2022, ending a string of 7 consecutive positive quarters. The S&P 500 finished the quarter down -4.60% while the tech heavy Nasdaq and the broader Russell 2000 closed down -8.91% & -7.53% respectively. Investors rotated out of growth-oriented, high-P/E technology stocks in favor of stocks in sectors exposed to the traditional economy which, generally speaking, trade at a cheaper valuation relative to the tech sector. Interestingly, much of the difference be the return in the S&P 500 and Nasdaq came from the positive return in the energy sector which is up 39% this year.

    From an investment style standpoint, value massively outperformed growth in a reversal of what has been the trend since the onset of the pandemic. Elevated volatility, geopolitical uncertainty, and the prospect of quickly rising interest rates caused many investors to flee richly valued, growth-oriented tech stocks and rotate to value oriented sectors of the market.

    On a sector level, only two of the eleven sectors in the S&P 500 finished the first quarter with a positive return. Energy, up +39.03%,was the clear standout as the sector benefitted from the increase in geopolitical uncertainty and subsequent surge in oil and natural gas prices in response to the Russia-Ukraine war. Also, utilities, which have been a traditionally defensive sector, logged a modestly positive return (+4.77%) as investors rotated to defensive sectors in response to elevated market volatility and geopolitical uncertainty. Finally, financials relatively outperformed the S&P 500 and saw only a small loss as the sector has historically benefited from rising interest rates, although concerns about exposure to the Russian economy weighed on many financial stocks in February and early March.

    Foreign markets also declined in the first quarter. The MSCI EAFE which tracks foreign developed countries was down -5.79% while the MSCI Emerging Markets index fared slightly worse, down -6.92%. Geopolitical uncertainty hit foreign markets early in the quarter, erasing what was moderately positive
    performance until that point. Emerging markets slightly lagged foreign developed markets due to a stronger U.S. dollar and rising geopolitical risks, but the underperformance was modest.

    Switching to fixed income markets, bonds registered some of the worst performance in years during the first quarter with most major bond indices declining as investors exited fixed income holdings in the face of high inflation and as the Federal Reserve consistently signaled that it was going to raise interest rates faster than investors had previously expected.

    Looking deeper into the bond markets, shorter-term Treasury Bills outperformed longer-duration Treasury Notes and Bonds as high inflation and the threat of numerous future Fed rate hikes weighed on fixed income products with longer durations.

    In the corporate debt markets, investment-grade bonds saw materially negative returns and underperformed lower-quality but higher-yielding corporate debt, which also declined but more modestly. This underperformance in investment-grade debt reflected the impact of rising Treasury yields, while the outperformance of high-yield corporate bonds served as a reminder of the still-positive outlook for the U.S. economy and corporate America, despite the macroeconomic headwinds of inflation, geopolitical unrest, and rising interest rates.

    US Bond Indexes, Q1 Return and YTD Return Chart

    Second Quarter Market Outlook

    As we start a new quarter, markets are facing the most uncertainty since the pandemic, as headwinds from inflation, less-accommodative monetary policy, and geopolitics remain in place.

    Inflation still sits near a 40-year high as we start the second quarter and with major commodities such as oil, wheat, corn, and natural gas surging in response to the Russia-Ukraine war, it’s unlikely that key inflation indicators like the Consumer Price Index will meaningfully decline anytime soon. Until there is a definitive peak in inflation, the Federal Reserve is likely to continue to raise interest rates, which may become a drag on economic growth if too high.

    The Federal Reserve, meanwhile, has consistently warned markets that aggressive interest rate hikes are coming in the months ahead, and this quarter we expect the Fed will reveal its balance sheet reduction plan, which will detail how the Fed plans to unload the assets it acquired via the Quantitative Easing program over the past two years. If the details of this balance sheet reduction plan are more aggressive
    than markets expect, or the Fed commits to more rate hikes than are currently forecasted by markets, the affects will weigh on stocks and bonds alike.

    Finally, the Russia-Ukraine war continues to rage on, and the geopolitical implications have spread beyond the battlefield, as relations between Russia and the West have hit multi-decade lows. Meanwhile, crippling economic sanctions against Russia remain in place, while commodity prices are still elevated, and the longer those factors persist, the greater the chance we see a material slowdown in the global economy.

    While there are risks to continued market volatility as we start the new quarter, it’s also important to note that the U.S. economy is strong and unemployment remains historically low. Both factors that support asset markets and continued growth, but perhaps a little slower. Additionally, while interest rates are rising, they remain below levels where most economists would forecast that they would begin to slow the economy. Finally, consumer spending, which is one of the main engines of growth for the U.S. economy, is robust, and corporate and personal balance sheets are healthy and stronger than at the beginning of the Pandemic not to mention before the Financial Crisis.

    In sum, the outlook for markets and the economy is uncertain, and we should all expect continued volatility across asset classes in the short term. But core macroeconomic fundamentals remain very strong while U.S. corporations and the U.S. consumer are, broadly speaking, financially healthy. So, while risks remain, as they always do, there are also multiple positive factors supporting markets, and it is important to remember that a well-executed and diversified, long-term financial plan can overcome bouts of even intense volatility like we saw in the first quarter.

    We understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Successful investing is a marathon, not a sprint, and even temporary bouts of volatility like we experienced over the past three months are unlikely to alter a diversified approach set up to meet your long-term investment goals.

    Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.


     

    The Information contained in this document is based on data received from third parties which we believe to be reliable and accurate. YorkBridge Wealth Partners, LLC has not independently verified the information and does not otherwise give any warranty as to the truth, accuracy, or completeness of such third party data, and it should not be relied upon as such. Any opinions expressed herein are our current opinions only.  YorkBridge Wealth Partners, LLC is an SEC Registered Investment Adviser under the Investment Advisers Act of 1940 (“Advisers Act”).  Registration of an investment advisor does not imply any specific level of skill or training. The information contained in this document is to assist with general planning. Please consult with your own tax advisor and attorney for more specific information.