Key Takeaways:
1. U.S. equity markets rebounded in March after their fifth worst start to a year since 1928.(2)
2. TSA checkpoint data, restaurant reservations, and hotel occupancies are near or exceeding pre-pandemic levels.(7)
3. The average stock in the S&P 500 experienced a drawdown of 20% in Q1.(8)
Equity markets rebounded in March after beginning the year historically lower. The U.S. Russell 3000 Index finished the quarter down -5.28%, the MSCI World Index was down -5.15%, and the Bloomberg Aggregate Bond Index was down a staggering -5.93%.(1) For bonds, this was the second worst start to a year since 1928.(2) Coming into 2022, investors thought markets would be driven by uncertainties around inflation and Federal Reserve policy, and less so due to COVID-19. But so far this year, Russia’s invasion of Ukraine has been the unexpected story.
Russia’s invasion of Ukraine in February shocked geopolitical experts. What U.S. Intelligence officials initially expected to be a swift Russian victory, has turned into a prolonged war and humanitarian crisis. The merciless bombing of Ukrainian cities has led to millions fleeing their homes and unnecessary civilian casualties. (3) On the other side, it is estimated that tens of thousands of Russian soldiers have been killed, captured, or are missing in action. Despite these atrocities, in what may represent a pivotal moment for world order, Ukrainian President Volodymyr Zelenskyy has stood firm, inspiring not only the Ukrainian resistance but the western world into providing both military aid and unprecedented economic sanctions on Russia. Despite the senseless violence and crippling sanctions, U.S. markets are up 5.31% since the invasion began.(1)
It is important to put this year’s stock market volatility in perspective. Over the past 40 years stocks experienced an average intra year drawdown of -14.0%, but still averaged an annual return of +13.6%.(5) So far, 2022 is no exception, as the stock market had its fifth worst start since 1928.(2) Since the market bottomed on March 14th, stocks have moved higher by 8.66%. March 23rd also marked two years from the stock market’s COVID-19 bottom. Since that day, the S&P 500 has doubled.
In a typical portfolio, bonds are meant to provide stability, generate income, and provide diversification from equities. Bonds generally underperform stocks in rising markets due to their lower level of risk. However, so far this year, bonds are underperforming equities in a declining market. With inflation on the rise, central banks are increasing interest rates to slow down rising prices. As interest rates go up the price of existing bonds in the market go down, as investors can now buy newly issued bonds with higher interest rates.
Despite the Fed’s signals of rate increases last fall, inflation continued to move higher in the first quarter. Personal Consumption Expenditures (“PCE”), the Federal Reserve’s preferred measure of inflation, rose to 6.4% year-over-year at the end of February.(1) To combat this increase, the Federal Reserve raised the overnight Federal Funds rate by 0.25% in March, the first interest rate increase since the pandemic began. In a March press conference, Jerome Powell hinted that the Fed may accelerate the pace of future rate hikes when he said that they need to address inflation “expeditiously”. With the bond market already pricing in at least seven rate hikes in 2022 alone, and economists signaling that U.S. economy economic growth is slowing, Powell will need to navigate carefully to ensure a soft landing of the economy and avoid an economic recession.
JFG Outlook
There is growing cynicism on globalization following Russia’s invasion of Ukraine. After decades of outsourcing domestic production for cheaper costs, the reliance on foreign countries for critical resources has come into question. Europe is a prime example, as reductions in traditional domestic energy production in favor of environmentally friendly renewables led to the continent becoming dangerously reliant on Russian oil and natural gas. To avoid these mistakes, the CEO of J.P. Morgan, Jamie Dimon, suggested to the Biden Administration that the US needs a “Marshall Plan” for future
investments in fossil fuels and renewable energy.(6)
A similar trend can also be seen in the semiconductors industry. While the vision of semiconductors began in Silicon Valley, most manufacturing takes place in Taiwan. According to the White House, Taiwan produces 90% of advanced semiconductor chips.(4) China is increasingly calling for a “reunification” with Taiwan, and its feared that a military conflict would create a national security threat for the West. Decades of complacency will likely cause countries to reconsider domestic manufacturing for national security. We believe that this trend will create new opportunities around manufacturing and energy in the U.S.
In the near term, we expect increases in consumer spending on services to power the U.S. economy. During the pandemic, demand for physical goods increased dramatically as stimulus checks rolled in and most service industries were closed. But as COVID-19 hospitalization rates hit all-time lows, we see TSA checkpoint data, restaurant reservations, and hotel occupancies near or exceeding pre-pandemic levels.(7) We believe these reopening trends will continue into the summer as consumers shift their spending from
goods to services.
In our previous commentary, we suggested a multi-year rally in the stock market, and changing rhetoric from the Federal Reserve, called for a review of investors’ equity allocation. Part of our thought process included rebalancing towards companies with strong business models and healthy balance sheets. In the 1970’s, high quality companies in sectors such as industrials, financials, and consumer staples were some of the best ways to protect wealth against inflation. But in 2022, investors now have high quality technology stocks to consider, whose input costs are likely less impacted by inflation. We remain skeptical of investing in companies just because their stock prices are down 50, 60, and in some cases 70% from their 52-week highs. As the Federal Reserve reduces the money supply, we believe a well diversified portfolio with high-quality businesses is the only way to combat uncertainty in the equity market.
To offset the risk of inflation and rising rates in bond portfolios, we believe that investors should remain overweight in short duration bonds and floating rate debt. The current selloff in longer duration bonds has created some opportunities for new investment, as the market has already factored in seven rate hikes without any action from the Fed. The two-year U.S. treasury yield is now 2.29%%, up 2.03% in just six months. The yield on the two-year U.S. treasury has not been this high since May of 2019, and before that stretch you would have to go all the way back to 2008 to earn such a return.(1)Defensive investors in cash can now offset the eroding effects of inflation with higher bond yields.
In conclusion, after a volatile start to the year, we remain disciplined and focused on our client’s investment objectives. Investors should continue to assess how their portfolio can handle rising interest rates and inflation, and search for opportunities after a major drawdown in the first quarter.
Thank you for your continued trust in the Juno Financial Group.
Sources
1. FactSet
2. https://www.forbes.com/sites/kristinmckenna/2022/03/14/its-been-one-of-the-top-5-worst-starts-to-a-year-for-stocks-andbonds/?sh=28e43c4d6fca
3. https://www.wsj.com/articles/ukraine-humanitarian-crisis-worsens-as-biden-heads-to-europe-11648031069?mod=mhp
4. https://www.nytimes.com/2022/01/26/us/politics/computer-chip-shortage-taiwan.html
5. https://www.lordabbett.com/en-us/financial-advisor/insights/markets-and-economy/dealing-with-volatility--key-concepts-for-investors.html
6. https://www.marketwatch.com/story/jamie-dimon-tells-biden-that-u-s-europe-need-marshall-plan-for-energy-independence-report11648005820
7. FirstTrust Research
8. Charles Schwab Research