— 2022 Q1 UPDATE —
Summary:
Quarter 1 (Q1) was marred by negative equity returns and negative bond returns due to rising interest rates, decreasing consumer confidence, rising inflation, and fear over the Russia-Ukraine war.
Growth stocks underperformed value stocks because rising interest rates have an outsized impact on relatively higher valuations.
Fixed-income returns were negative due to the yield curve shifting higher from the Federal Reserve (Fed) slowing their bond-buying and inflation changing the supply-demand characteristics of buying fixed income. Generally speaking, longer duration fixed income under-performed shorter duration fixed income because interest rate changes have a larger impact the higher the duration is.
Inflation continued to hit 40-year highs, with energy cost increases having the highest impact on the increases.
The labor market heated up with unemployment moving lower and the labor force participation rate moving higher. This phenomenon was primarily due to inflation, the reverse wealth effect (asset values dropping), and decreased government transfer payments forcing people back into the labor force.
Q1 Market Returns:
Source: Y-Charts
Source: Author
See important disclosures at the end of document
Equity Style Snapshot Benchmarks: Large Value – CRSP US Large Cap Value Index Total Return, Large Blend, CRSP US Large Cap Index Total Return, Large Growth – CRSP US Large Cap Growth Index Total Return, Mid Value – CRSP US Mid Cap Value Index Total Return, Mid Blend – CRSP US Mid Cap Index Total Return, Mid Growth – CRSP US Mid Cap Growth Index Total Return, Small Value – CRSP US Small Cap Value Index Total Return, Small Blend - CRSP US Small Cap Index Total Return, Small Growth – CRSP US Small Cap Growth Index Total Return> The Center for Research in Security Prices (CRSP) is a provider of research-quality, historical market data and returns. Once securities are assigned to a size-based market cap index, they are made eligible for assignment to a growth or value index using CRSP’s multifactor model. Securities are scored for both Value and Growth factors, then ranked. Investors cannot invest directly in a benchmark.
On Inflation:
Inflation numbers continued to make 40-year highs in Q1, with energy prices being the largest contributor to the statistic. There are plenty of reasons for the continued increase in inflationary numbers, but the main culprits are supply chain issues, high aggregate demand due to pent-up savings, and the exogenous shock of the Ukraine-Russia war.
Source: FRED
Since supply chains are a complex system and the Russia-Ukraine war does not appear to have an end in sight, the main way for the supply chain issues to alleviate is through a reduction in aggregate demand, which brings us to the labor situation.
On Labor:
The unemployment rate has been under 4% since December of 2021, which is considered close to full unemployment. However, the often-overlooked labor force participation rate was still a couple of percentage points below pre-pandemic levels, which meant that millions of adults simply did not come back to the labor force. The two main reasons people were able to drop out of the labor force were because of the wealth effect from asset price inflation and government transfer payments, both of which gave Americans the highest-inflation adjusted gross savings ever. However, the labor force participation rate saw around a half percent increase in Q1, which means that people are coming back to the labor force.
Source: FRED
Source: FRED
The main reason the labor force participation rate has recovered so much lost ground in Q1 was mainly due to inflation-adjusted gross savings continuing to fall due to reduced government transfer payments, 40-year high inflation numbers eating savings, and a reduction in the wealth effect due to falling asset prices.
On the Fed's Taper and Balance Sheet Purge:
The Federal Reserve has acknowledged the inflationary pressures the economy is under, and they also realize that the labor market is beginning to recover. This has led them to declare they were going to begin “tapering” their bond-buying program last year, which they subsequently have. [3] However, with inflation at 40-year highs, the Fed has signaled they were going to begin to reduce their bond holdings at a maximum of $95 billion per month. [4] This would be the opposite of quantitative easing, which is appropriately named quantitative tightening. This would entail a combination of the Fed selling their $8.5 trillion in government securities (Treasuries and Mortgage-Backed Securities) in the open market and letting some of those securities mature every month, for a combination of reducing the balance sheet by $95B per month. By letting these securities begin to mature or by selling these securities, the Fed is anticipating an increase in longer-term interest rates, a reduction in asset prices, and a slowing of aggregate demand.
Source: FRED
Source: FRED
At the end of Q1, the much worried about aggressive taper has come to fruition but the balance sheet exodus has not yet begun. With the balance sheet currently having a record level of securities sitting on it, the biggest difference is that the Fed is not currently buying up securities the same way they were before. Instead they seem to be simply holding their balance sheet relatively steady.
On Interest Rates:
The Fed also raised short-term interest rates in Q1, with the agenda of raising short-term interest rates a handful more times throughout 2022 to help slow inflation. [5] Even with this interest rate hike, short-term interest rates are still at historic lows.
Source: FRED
Source: FRED
The shape and evolution of the yield curve over the past 2 years shows how the entire yield curve has shifted upwards as the economy has reopened and inflation has taken hold, but it also shows how the shape of the yield curve has changed too. At the end of Q1 2021, the yield curve had a smooth upward trajectory, a bullish indicator for the economy. However, at the end of Q1 2022, the yield curve more closely resembled a yield cliff due to forward expectations of more short-term rate hikes and the engineering of longer-term rates by the Fed. There are also inversions and kinks throughout different tenors of the yield curve, which is a more bearish signal in nature.
Source: Y-Charts
Source: Author
Projections or other information regarding the likelihood of various outcomes are hypothetical in nature, do not reflect actual results and are not guarantees of future results. Additionally, it is important to note that information in this report is based upon financial figures input on the date of this report; results provided may vary.
General Market Summary:
Q1 was not an ideal quarter for investors in equities and fixed income due to all the previously mentioned factors. Rising interest rates have had an outsized effect on richly valued equities and longer duration fixed income. If interest rates continue to rise that will most likely continue to be the case and the previous asset class trends will most likely continue as long as interest rates continue to rise. However, all markets have cycles and different assets will perform better in different parts of different cycles and it is extremely difficult to predict which part of a cycle you are in and the timing of when they will change. Therefore, we advocate for a widely diversified portfolio full of quality assets that can take advantage of different parts of the market cycles at different times and withstand the test of time. This diversification and strategic asset allocation can allow investors to take advantage of good parts of the market cycles and withstand the difficult parts as well. The key is sticking with the plan.
Conclusion:
Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are at the forefront. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!
Sources:
- ycharts.com
- Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
- What is the Fed taper? An economist explains how the Federal Reserve withdraws stimulus from the economy (theconversation.com)
- FOMC Minutes: Fed Officials Weigh Shrinking Balance Sheet by $95 Billion a Month - Bloomberg
- The Fed Might Raise Rates by a Half-Point. How It Could Play Out. | Barron's (barrons.com)
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss.
The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ. The DJIA was invented by Charles Dow back in 1896. The MSCI ACWI ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries. With 2,312 constituents, the index covers approximately 85% of the global equity opportunity set outside the US. The Nasdaq Composite is an index of the common stocks and similar securities listed on the NASDAQ stock market and is considered a broad indicator of the performance of stocks of technology companies and growth companies. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 3000 Index consists of the 3,000 largest U.S. companies as determined by total market capitalization. It assumes the reinvestment of dividends and capital gains and excludes management fees and expenses. Morgan Stanley Capital International (MSCI) EAFE Index (Europe, Australasia and Far East) is an index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in major international equity markets as represented by major MSCI indexes from Europe, Australia and Southeast Asia. The MSCI AC Asia Pacific Index captures large and mid cap representation across 5 Developed Markets countries and 8 Emerging Markets countries in the Asia Pacific region. With 1,546 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) and is a float-adjusted market capitalization index that is designed to measure equity market performance in emerging markets. It consists of indices in 23 emerging market country indexes. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe. With 440 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe Bloomberg U.S. Aggregate Bond Index is a composite of four major sub-indexes: US Government Index, US Credit Index, US Mortgage-Backed Securities Index, and US Asset-Based Securities Index, including securities that are of investment grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million. Investors cannot invest directly in an index.
Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.