The first quarter of 2022 (Q1) felt like the start to a year when investors couldn’t catch a break. We finally seemed to be turning a corner from the pandemic and there was a sense of guarded optimism as the new year opened. It didn’t last long. Inflation concerns grew, but the real drop in sentiment came when Russia invaded Ukraine. Investors quickly sold off stocks, especially those that had performed best last year. Investors also had to contend with the Fed raising interest rates for the first time in years and, in the quarter’s waning hours, the bad omen of an inverted yield curve. Quite the quarter indeed!
Here’s a roundup of how major markets performed during the first quarter:
- US Large Cap Stocks: down 4.6%
- US Small Cap Stocks: down 7.5%
- US Core Bonds: down 5.9%
- Developed Foreign Markets: down 6.5%
- Emerging Markets: down 7.6%
Stocks had been down modestly to start the year but turned sour as chances grew for war in Europe. Noticeable dips for the S&P 500, the typical benchmark for US stocks, occurred during late January with the increase of rhetoric and troop buildup, and then again a month later on news of the invasion itself. At its lows, the S&P 500 was down over 12%, technically a correction, and the tech-heavy NASDAQ dropped a hair over 20%, technically a bear market. Both indexes regained ground in March to end the quarter with relatively modest losses.
With swift nearly-global condemnation of Russia, a major oil and gas exporter (as well as other important commodities), oil prices rose dramatically, sending the US energy sector up 39% for Q1. Utilities were up almost 5% for the quarter, but all other major sectors finished Q1 in the red. The worst performing sectors were Consumer Discretionary and Tech, down 9% and 8%, respectively, both top-performing sectors during 2021. Foreign stocks and emerging markets had begun the year well, but quickly turned south on news of the invasion.
And then there was the bond market. Bond prices had struggled throughout much of 2021 and limped into Q1. The main issue last year had been the prospect of inflation and the eventual response by the Fed to try and contain it. When inflation started to take off last Fall, bond prices reacted negatively. This worsened during Q1 as inflation reached 7.9% in February. Add uncertainty about further inflation and the Fed finally starting to raise short-term interest rates in March, and you have a gloomy environment that saw core bonds fall almost 6% during the quarter. Short-term bonds and long-term bonds fell about 2.5% and 10.6%, respectively. This poor performance is tough to swallow because high-quality medium-term bonds are typically an anchor in our portfolios during turbulent times.
But that’s when we’re not also contending with potential runaway inflation potentially leading to faster Fed rate increases, that potentially lead to a recession. Put simply, the outlook for all three is uncertain. Bonds of different maturities and interest rates (yields) are compared to each other to gauge how investors are feeling (and acting) about economic growth, inflation, and the expected path of interest rates over a certain time horizon. Comparing bond yields like this creates a variety of “yield curves” and, although different inferences can be drawn from watching the shape of the curves over time, people mostly watch them for recession risk. The most popular curve is the difference in yield between the 2yr and 10yr Treasurys. Normally this curve slopes upward from the lower yield of the 2yr to the higher yield of the 10yr and is a sign of expected smooth sailing. But briefly, and by a small amount, the curve inverted right as Q1 ended.
One of the reasons the 2yr/10yr curve is so popular is that its inversions are said to have predicted six out of the last six recessions. To be clear, inversions don’t cause a recession, but are coincident with them. An inverted yield curve also doesn’t say much about the depth and breadth of a recession, it’s more of a warning sign. It’s possible that an upcoming recession could be mild, more a response to the ongoing shockwaves from the pandemic and consumers exhausted (financially and emotionally) from all their recent spending, and not deep structural issues such as what led to the Great Financial Crisis. Why would we expect a recession amid all the news of rapid economic growth, rising prices, and low unemployment? Bond investors may be getting ahead of themselves, but the general thinking is that the Fed could fight too hard to slow inflation and raise interest rates too quickly, essentially torpedoing our recovery. For its part, the Fed plans to stair-step the short-term benchmark rate it controls higher throughout this year and into next and will be sensitive to how this plays out in the economy along the way. Bond investors are skeptical.
The timing of yield curve inversions typically leads recessions by a year or so, and the inversion itself needs to stick around for a while to be more predictive. Stocks typically do well post-inversion and bond prices already have much of this Fed/recession risk priced in. What’s a long-term investor supposed to do in an environment like this? You should have a good plan and stick to it. Stay diversified. Rebalance by adding to stocks on weakness and don’t be shy about adding to bonds, especially as interest rates rise. You can also harvest losses in non-retirement accounts. Oh, and try not to get swayed by the headlines. Nothing to it, right?
Have questions? Ask me. I can help.
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