"The belief in the possibility of a short decisive war appears to be one of the most ancient and dangerous of human illusions." --Robert Wilson Lynd
The events of the last two months are a distressing reminder that armed conflicts between large, developed nations are still possible, despite our apparently misguided notion that modern societies have somehow eliminated war as a way of solving political disagreements.
As unsettling as this may seem, we must come to terms with the fact that the war in Ukraine is likely to be a prolonged conflict and humanitarian tragedy with far-reaching short- and long-term consequences for global political order and the way nations conduct business with one another.
First Quarter Summary
The immediate effect of the war was to accelerate an already weakening stock and bond global investment environment. After an 18.5% return in 2021, global stocks fell -5.4% in the first quarter of 2022 as measured by MSCI’s All Country World index (all numbers hereon are through March 31, 2022).
US stocks dropped -5.3% (Russell 3000) and ex-US stocks fell -5.6%. US Small Cap stocks fell -7.5%, exceeding the loss in large cap stocks -4.6% (S&P 500). US Large Cap Value stocks outperformed their Growth counterparts by a significant margin (+0.2% vs. -8.6%).
US Fixed income, as measured by the Bloomberg Barclay US Aggregate Bond Index, fell -5.9% in the quarter as interest rates rose to 2.32% up from 1.52% (10 Year Treasury Yield) at the beginning of the year.
There were very few places to hide in fixed income: short corporate bonds fell -4.2%, while long-duration Treasuries dropped -10.6%. Short duration inflation protected Treasury bonds (“TIPS”) held up best and fell only -0.3%.
Commodity prices soared more than 25% in the first quarter. Gold increased +6.7% and oil prices rose to over $100 per barrel from $75 on December 31. Inflation also increased to 8.5%, its highest year-over-year rate since 1981 (CPI). The impact of inflation and the war on consumer sentiment has been dramatic. Consumer sentiment dropped to 59.4 in March, its lowest reading since November 2011.
While there has been no end to the bad news in the last few months, we see glimmers of hope ahead. For example, the economic effects of the Covid-19 pandemic finally appear to be fading. Most Americans have either been vaccinated or infected and this immunity is gradually reducing fatalities, even with the arrival of the new strains. By some estimates, Covid-19 is now less deadly than the seasonal flu.
US GDP grew 5.5% year over year during the fourth quarter of last year, despite ongoing supply shortages. By the end of 2021, the U.S. economy had not only recovered its pre-recession output level but had exceeded it by 3.2%. Importantly, part of this recovery is due to productivity gains: over the past two years, as output per worker has grown at an annual rate of 2.7%, more than twice the 1.2% growth seen in the first two decades of this century.
Consumer spending on leisure, travel, and entertainment continues to recover and his new spending should add extra momentum to economic growth over the spring and summer of 2022. In addition, the increased use of technology during the pandemic, such as zoom meetings, look to be a permanent adaptation, leading to productivity gains in the labor markets.
While the war in Ukraine has certainly increased odds of a global recession, it is still possible that the US economy will absorb the effects of the war and avoid one. Despite the higher energy and gasoline prices, the U.S. is now well insulated from an oil shock. U.S. consumers spend only 4% of their disposable income on oil/gasoline. In addition, as the US is effectively self-sufficient as an oil producer, we are less subject to the effect of higher imported oil prices.
We expect stronger economic growth in the second quarter of 2022, spurred by robust consumer and delayed business spending. In the second half of the year, we are likely to see a slowdown as the economy absorbs more restrictive fiscal and monetary policy. Current consensus is that real GDP growth in the U.S. will be around 3% in the fourth quarter and the further slowing to about 2% in 2023 but avoiding a contraction/recession.
The labor market has continued to improve rapidly, with the unemployment rate falling to 3.8% in February 2022 compared to 6.2% a year earlier. Even so, there is a massive excess demand for labor, with the latest data showing roughly 5 million more job openings than unemployed workers, which should lead to further declines in the unemployment rate. It is possible that by the end of this year the unemployment rate will have fallen below 3.4%, touching the lowest unemployment rate since 1953.
Inflation and Interest Rates
Inflation has risen significantly over the past year, driven by limited supply and surging consumer spending. The collective hope that inflation would merely be “transitory” has proven to be misguided. While supply-chain issues should fade, there is a lot of uncertainty about how long high inflation will be with us.
Rising inflation and tight labor markets have motivated the U.S. Federal Reserve to aggressively raise interest rates and reduce their bond holdings. However, their job is complicated by the uncertainty surrounding China’s ongoing battle with Covid and the war in Ukraine, which could cause further supply chain issues, but also lead to a global economic slowdown.
We do not think inflation will return to pre-pandemic levels for at least two more years. It is likely to moderate from current high rates later this year, but then we expect it to remain elevated in the 3-5% range going forward, with unknown implications for housing, consumer sentiment, and monetary and public policy.
2022 will continue to be a challenging year for fixed income investors, although higher yields and a moderation in economic growth by the end of the year might portend a better 2023.
Earnings for the S&P 500 have recovered spectacularly since the big declines in early 2020 and hit a new all-time high in 2021. This partly reflects stellar profits in some of the most important sectors of the U.S. equity market (technology, health care), but also a rebound in many of the cyclical sectors that struggled the most in 2020. More generally, earnings have been bolstered by powerful consumer demand and higher productivity as businesses have been able to reduce costs in a more virtual environment.
As earnings grew and markets fell, U.S. equity valuations fell back significantly in early 2022. Thus far, earnings for the first quarter have been a little better than expected and we have hope that corporations can navigate the challenges ahead. Rising interest rates will make it difficult to justify an increase in P/E multiples, while rising wages, slowing nominal GDP growth and inflation should impede real earnings gains. However, in inflationary periods most businesses have the ability to pass increased costs on to consumers and this may be the silver lining for the U.S. corporate earnings.
After many years of strong outperformance by growth stocks, most notably during the pandemic in 2020, value stocks have begun to recover as the combination of high commodity prices and rising interest rates have boosted the chances of a long-overdue rotation. The sectors which are most closely associated with value stocks are utilities, energy, consumer defensive, industrials, and financial services. Value stocks still remain at historically cheap levels relative to growth while providing substantially higher dividends.
In response to the above dynamics, we have made investment portfolio adjustments to try and better align them with the new global reality.
Specifically, we increased exposure to commodities and to the US aero-space and defense sectors, while reducing exposure to high yield fixed income. Combined with our previous exposure to short-term US TIPS and US Large Cap Value stocks, these modest allocations should better protect the portfolios from the expected interest rate increases and higher-than-expected inflation. Our new exposure to the US defense and aero-space sectors of the US reflects our belief that the war in Ukraine will lead to a long-term rearmament across the world and especially in NATO countries.
Looking forward, we will continue our rotation into value-oriented stocks by looking to increase our allocation to non-US high dividend stocks, as they seem to have overcorrected following the start of the war in Ukraine. This will probably be done gradually over the coming quarters.
It is important to remember that the fall in bond and stock returns in the first quarter of 2022 follow on the heels of impressive positive portfolio returns in the prior three years, which naturally leads to a period of consolidation, correction, and higher volatility. These periods are a normal part of how markets function and cannot be avoided.
Achieving inflation-beating long-term returns and your financial goals means having an effective investment process that includes effective diversification and prudent rebalancing, especially during times of seeming market adversity.
In closing, in this Easter season, we remind ourselves that faith and love will overcome even war and strife and that the essential nature of humanity is our goodness. May this season’s hopefulness carry you through the next months and years to come.