April 8, 2022
The first quarter of 2022 was volatile. Stocks corrected, but a rally in March lessened the year-to-date decline. Bond returns experienced their worst quarter in over thirty years. The markets were vulnerable to concerns over rising inflation rates and the prospects for an increasingly aggressive monetary response. These concerns caused a substantial rise in U.S. interest rates for maturities two years and beyond. European interest rates exhibited a similar pattern. These concerns were exacerbated by Russia’s invasion of Ukraine, although the U.S. was considered less impacted by the war than Europe.
The key to prospective U.S. equity returns will be the ability of the Federal Reserve to achieve a decline in inflation without causing a recession. Recent indications from Federal Reserve officials reflect a determination to move aggressively to bring down the inflation rate through significant increases in the Federal Funds rate and a reduction in the size of the Federal Reserve balance sheet. The reduction will be a process, as the Fed’s current balance sheet level is $9 trillion, which has substantially increased since March of 2020 to mitigate the impact of the pandemic. The Fed is quickly adjusting from a near-zero rate policy to a low-interest rate policy. It is unlikely to tighten monetary policy to “restrictive” levels near-term, as during the Paul Volcker-led Federal Reserve during the 1980s.
Monetary policy will tighten, but the current pace of expected hikes is not exceptional vs. prior cycles:
Source: BCG Center for Macroeconomics
The U.S. economy remains robust, as reflected in strong job creation and the low unemployment rate. However, there are already indications that the rate of economic growth in the U.S. is beginning to slow. Pockets of slowing are natural as the economy digests the rapid recovery of 2021, and slowing demand responses will alleviate areas of high inflation. One area being impacted is homebuilding due to a sharp increase in 30-year mortgage rates from less than 3% late last year closer to 5%. Also, tight inventories are negatively impacting car sales, freight demand is showing signs of declining, and there are indications consumers are responding to higher prices on staples by changing purchasing patterns.
This year, corporate earnings surprises remain positive, which is critical for a constructive outlook for the markets. U.S. companies continue to demonstrate flexibility to counteract the impact of supply chain problems and labor shortages on revenue and profits. The Russian invasion of Ukraine has created additional inflation pressures (especially for commodities) and global trade issues. Our year-ahead view of solid earning growth in 2022 into 2023, driving higher share prices, assumed improved global supply chains – a prolonged war creates risks.
The earnings outlook has improved for 2022, while investor uncertainty and risk aversion have caused a multiple contraction of almost -10%, leading to market declines:
Source: Compustat, FactSet, J.P. Morgan Asset Management. *Earnings and multiple growth are percent changes over the next 12 months.
The U.S. economy is much stronger than Europe’s economy. European economies have yet to recover to pre-pandemic trend levels and have been harder hit by the war in Ukraine. The economy of China is being negatively impacted by the upsurge in COVID cases and efforts to unwind problems in the real estate sector. Given these economic prospects, an optimistic long-term outlook remains warranted for the U.S. equity market. Selectivity is essential, emphasizing the shares of U.S. companies that can withstand the impact of slower growth and higher inflation and have strong balance sheets. We focus on multi-national companies with solid fundamentals in international markets, trading at discounts to U.S. peers. We believe this approach should prove rewarding, even with a less favorable economic background (but it has required patience!).
With elevated uncertainty and volatility, our goal is to preserve the solid equity gains of prior years. Our focus on high-quality companies and dividend growth led to favorable relative results for our investment strategies vs. the major indices. We also evaluate performance during volatile times by upside/downside capture ratio, focusing on losing less on down days and fully participating with the market on up days.
New portfolio additions in 2022 have focused on increasing value and stability factors with inflation hedges, including increases to industrials with pricing power and raw materials producers. We maintain a structural overweight to Technology but have lessened exposure. Our portfolio holdings sensitive to consumer spending struggled during the first quarter despite solid sales results due to fears of rising inflation and economic uncertainty negatively impacting consumer spending. Some of the most attractive “bargains” in the market are within Consumer industries. We believe the U.S. consumer remains healthy as high pandemic level savings rates decline, leading to pent-up spending. Households’ cash holdings increased by almost $2.5 trillion since early 2020:
The Russian invasion of Ukraine has fractured Western relations with Russia and has accelerated investment “megatrends” across sectors and themes. Two we have identified and positioned for include:
The outlook for global equities may not be as constructive as a year ago, but it is reflected in poor investor sentiment, historically a reliable contrarian bullish indicator. BofA’s Farrell Sentiment Indicator moved below 0.5, the lowest in 30 years. The S&P 500 tends to have better returns going out from one month to two years after this signal:
Empirical data supports a further market recovery if the U.S. economy avoids a recession; however, it suggests a bumpy ride. Market occurrences, including a 10% correction, elevated VIX index levels, and an inverted 2/10 year yield curve, have historically led to better than average market returns and increased the risk of significant market drawdowns. Discipline remains an essential investing virtue in 2022, and we will continue to build diversified portfolios focused on quality companies with growing dividends.
As indicated previously, U.S. interest rates for securities maturing in two years or more exhibited a substantial increase during the first quarter of 2022. The rise reflected evidence that inflation would be more persistent than anticipated, leading to a more aggressive Fed response. Yields on two-year Treasury securities increased from 0.7% to 2.3%, five-year Treasury yields increased from 1.3% to 2.5%, and ten-year Treasury yields rose from 1.5% to 2.3%.
Given the yield increases, we are gradually increasing the short duration of maturities in our clients’ portfolios. We are comfortable with the increased yields to selectively purchase investment-grade corporate bonds with maturities in the two-to-three-year range, which now provide 3% or more yield-to-maturity. A similar approach is being followed in municipal bonds for taxable portfolios, where tax-equivalent yields exceed corporates. We also utilize single maturity exchange-traded funds with similar durations and select ultra-short bond ETFs.
This report is for informational purposes only and contains data based on information from Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable or the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.