A return to normalcy as the pandemic moves to the endemic phase was not in the cards for the first quarter of 2022. January started us off with a tech sell-off and losses in every major index, even as U.S. GDP surprised to the upside. February saw a huge spike in oil prices, especially near the end of the month as Russia invaded Ukraine. The Russian invasion of Ukraine and all of the tragedy that comes along with it — both physical and economic — were the focus in March.
The war in Ukraine is resulting in a tragic loss of human lives and livelihoods, and is impacting economies across the globe. While the U.S. is somewhat more insulated from the effects of the conflict than the Eurozone, we have certainly felt the pain from increased energy prices in an already-inflationary environment. It is difficult to predict the path forward as the conflict could resolve (or proceed) in multiple ways, but it is a near certainty that further economic pain will be felt worldwide.
While the future is uncertain, the past is in the books, and recent economic data is a mixed bag. U.S. GDP came in at a revised 6.9% annual growth rate for the 4th quarter, which translates to 5.6% for 2021 — a 37-year high. Of course, this strength was coming off of severely depressed levels in 2020 due to the pandemic lockdowns. Expectations are for more muted growth in 2022.
Inflation continues to spike upward, with the latest reading of Core PCE (the Fed’s preferred measure) showing an annual increase of 5.4%, the highest reading in 40 years. Inflation was occurring before Russia’s invasion of Ukraine and has only been exacerbated by the conflict as energy prices have faced continued upward pressure. Rising inflation has spurred the Federal Reserve into action, with the first of what is expected to be multiple rate increases taking place in March. The risk of a monetary policy mistake is high as the Fed struggles to find the right balance between containing inflation and not hurting economic growth.
The consumer was a key component of economic growth in 2021, but resiliency is being tested in this inflationary environment. Spending has been flat so far in 2022 as consumers must spend more on food and energy and less on discretionary purchases.
A strong labor market and built-up savings are helping the consumer weather the higher prices. The unemployment rate fell to 3.6% in March, just a hair over its pre-pandemic low of 3.5%, while the labor force participation rate also ticked up. It is worth noting that, historically, the U.S. has not gone into a recession when the labor market is strong. Wages increased by 5.6% year-over-year, a post-pandemic high. Consumer confidence remains fairly strong but is declining, with a reading of 107 at March 31, 2022, compared to 116 at the end of 2021.
After a meteoric rise, the housing market is starting to show some fractures as 30-year mortgage rates climb, hitting their highest level since 2018 at the end of March. After experiencing a lengthy period of increasing housing prices and home sales, existing home sales dropped 7.2% from January to February and 2.4% from a year earlier. New home inventories are at their highest level since mid-2008 and mortgage applications are falling.
Finally, political uncertainty remains as the Biden Administration works on a budget that may include corporate tax increases, and midterm elections loom later this year. Historically, midterm election years can be volatile, with large stock market drawdowns followed by increases as the election gets closer and the outcome is more certain. The S&P 500 has increased more than 32% on average in the 12 months following midterm election intra-year lows.
While we cannot dismiss the possibility of a recession in the United States, the resiliency of corporate earnings, high savings rates among consumers, and strong job market temper that risk for now.
The bond market showed substantial movement in the first quarter. The 10-year Treasury yield moved from 1.5% at the beginning of the quarter to 2.34% at the close, while the 2-year yield spiked from 0.73% to 2.33% over the same time period, causing a dramatic flattening of the yield curve.
The narrowing of the curve has led to much talk about yield curve inversion and its predictive power in terms of a recession. It’s worth noting that the 3mo/10yr curve has historically been more accurate in predicting recessions and that part of the curve is far from inverted. In addition, it is typically several months to a couple of years after inversion that a recession occurs.
The increase in rates led to negative returns across much of the fixed income market, with the Bloomberg Aggregate Index posting a loss of almost 6%, the third-worst quarter for that benchmark since 1976. The only area of the fixed income market to post positive returns in the first quarter was the ultra-short 3-month T-bill index.
The Federal Reserve is walking a fine line between containing inflation and overly restricting growth by being overly aggressive with tightening measures. They tapered their bond purchases last fall and wrapped up the program this quarter. The median FOMC member expects six more rate hikes this year, on top of the 25 basis point hike in March. Rate hike projections have changed wildly over the past few months and the ever-evolving economic data makes it tough to predict where we will end the year. However, it’s safe to say that rates are on an upward trajectory for the near future.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).
|Fixed Income Returns|
1st Qtr. 2022
Last 12 mo.
|BBerg US Aggregate Bond Index||-5.93%||-4.15%|
|BBerg Intermediate US Gov./Credit Index||-4.51%||-4.10%|
|ICE BofA US Corporate Bond Index||-7.74%||-4.31%|
|ICE BofA US High Yield Bond Index||-4.51%||-0.29%|
|BBerg Global Aggregate Bond Index||-6.16%||-6.40%|
|ICE BofA US Municipal AAA Securities Index||-6.12%||-4.60%|
After robust corporate earnings in 2021 and a solid stretch of strong performance, equities were forced to give back some gains in the first quarter in the face of high inflation, a hawkish Fed, and the war in Ukraine. U.S. equity averages posted their first quarterly loss in two years, with most of the decline occurring prior to the Russian invasion at the end of February. The Dow was down 4.1% for the quarter, while the S&P 500 and the Nasdaq were down 4.6% and 9%, respectively. The losses were more severe heading into March before a solid rally in the latter half of the month, leading the S&P and Nasdaq to rise 3.7% and 3.5%, respectively, while the Dow posted gains of 2.5% in the month.
Small and mid-cap stocks were not spared, with the Russell 2000 index (small cap) down 7.5% and the Russell Mid Cap index down 5.7% in the quarter. Small cap growth stocks were especially hard hit, with the Russell 2000 Growth index down 12.6% in the quarter compared to a smaller loss of 2.4% for the Russell 2000 Value index. After years of outperforming value, growth stocks were hit hard (especially early in the quarter) as is to be expected in an inflationary environment.
International stocks continued to lag their domestic counterparts in the first quarter. International developed markets were already behind the United States in terms of pandemic reopenings, and the war in Ukraine will have an outsized impact in this region as the Eurozone is more dependent on Russia for energy and both Russia and Ukraine for food. In addition, the dollar has rallied subsequent to the Russian invasion, which presents headwinds for international equity returns. The MSCI EAFE benchmark posted a loss of 5.8% in the quarter.
Emerging markets also declined, with the MSCI Emerging Markets index posting a loss of 7% in the first three months of 2022. Russia and Ukraine are both emerging market regions. After the severity of sanctions against Russia became apparent, Russian securities quickly became illiquid and many EM indexes removed Russian stocks altogether. While Russia was a small percentage of most EM indexes, it highlights the risks of investing in regions with political instability. On the flip side, many EM economies are net exporters of commodities that will benefit from the fast rise in commodity prices.
While there are several bright spots in the U.S. economy indicating resilience, the surge in rates and inflation is likely to weigh on corporate earnings and economic growth. There will likely be continued volatility as we bounce around between good news and bad news in the coming months. As companies start to report Q1 earnings in the coming weeks, their guidance will be watched closely for clues as to how the balance of the year will play out.
Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).
|Equity Indices||1st Quarter 2022||Last 12 mo.|
|Dow Jones Industrial||-4.10%||7.11%|
|S&P 500 Growth||-8.60%||18.15%|
|S&P 500 Value||-0.17%||12.54%|
|Russell 2000 (small-cap)||-7.53%||-5.82%|
|MSCI/EAFE (developed international)||-5.77%||1.70%|
|MSCI/EM (emerging markets)||-6.99%||-11.13%|
Nine of the 11 sectors posted losses in Q1. Communication Services led the way down with a drop of 12%. Consumer Discretionary, Information Technology, and Real Estate all posted steeper drops than the S&P 500 as a whole.
Conversely, the Energy sector had its best quarter since its inception in 1989 as oil and gas prices soared. Oil prices were volatile, with WTI crude surpassing $100/barrel in February for the first time since 2014, then spiking over $125 in the first half of March before bouncing up and down and settling the month at $100 as the U.S. announced plans to release oil from strategic reserves. One year ago, crude prices were around $61/barrel.
Somewhat surprisingly, Utilities had a strong quarter even in the face of rising rates. Typically, rising interest rates negatively impact utility stocks as conservative investors start to find bonds more appealing. Utilities also tend to have a high cost of capital and high debt levels — rising rate environments often increase those borrowing costs. The sector’s entire quarterly gain was realized in March. The 10%+ gain in the last month of the quarter was enough to overcome the previous two months’ worth of losses. While unusual, this is not the first time that Utilities have shown leadership in a rising rate environment, most recently in 2018. This reminds us that we can use history as a guide, but not a crystal ball.
The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).
|Return by Stock Sector||1st Quarter 2022|
|3. Consumer Staples||-1.01%|
|6. Basic Materials||-2.38%|
|8. Real Estate||-6.32%|
|9. Information Technology||-8.36%|
|10. Consumer Discretionary||-9.03%|
|11. Communication Services||-11.92%|
The Investment Overview is published quarterly by the Union Investment Management Group of Union Bank & Trust Company. Please address correspondence to: Union Bank & Trust, Attn: UIMG, PO Box 82535, Lincoln, NE 68501-2535.
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