In this commentary, we are going to talk about bonds. While we will get to the investment variety, we’ll start by focusing on the bonds that tie the spirit and solidarity of most of the world with the people of Ukraine. Watching the horrors beset upon the people of Ukraine, we cannot help but wonder how this could have happened and how this will end. Our hearts go out to the men and women who are trying to survive the unprovoked attack and pray that this conflict will end soon and without further bloodshed.
The war that started in February has united many in the developed world and even both political parties in this country, at least on this issue. However, while US/NATO countries and many other nations have joined together in sympathy and action, other countries have yet to condemn the attacks. Over the past 15 years, we have seen a marked shift in the world between authoritarian and democratically governed countries. The impacts of this are many highlighted by the need for energy disentanglement and independence in Europe. As the war continues, some bonds will be strengthened, and others frayed. So how might this impact investors?
Economically, companies tend to do what is in the best interests of their shareholders and customers. Jeff Kleintop, CIO at Charles Schwab, notes in a recent piece(1), that despite the political decoupling between the
U.S. and China and the recent move by the U.K. to exit the EU, the countries of the world remain tightly intertwined economically. He goes on to say that “the idea of economic globalization defined as sourcing production in one country with the lowest labor cost and exporting the final product to be sold everywhere else is now outdated. He noted that the rapidly growing digital economy is the next iteration in globalization that once focused primarily on manufacturing and that political deglobalization has not resulted in a stall in the sales of multinational companies nor a decline in the international portion of those sales. Finally, he notes, that “Political deglobalization could lead to some reshoring of industries deemed essential and some companies linked to national security issues may be impacted.” We expect that globalization will continue and evolve despite the war but that the past two-plus years have invited a new set of challenges.
The wars’ impact on inflation, goods shortages, and supply chain delays has been well documented. Russia’s war is threatening to thrust Europe into recession, is inducing painful food and energy shortages in Africa and the Middle East and is sowing the seeds of social unrest in the many countries feeling the impact of the war from afar. The climate of uncertainty this quarter caused a spike in volatility and a big haircut in the prices of many heretofore high-flying stocks. Stocks whipsawed and we expect this will continue. With little clarity on the war and the efficacy of the Fed’s plans (more later), it feels as if we are in for a bumpy ride. The wall of worry is high, but markets have historically found a way to climb it.
First Quarter Market Review
• The war in Ukraine, surging inflation, and rising interest rates led markets lower in the first quarter. After a strong 2021, US equities saw their first quarterly loss in two years. During the quarter at its worst, US equities fell 13% and thus into official correction territory (defined as a drop of 10%). While this may be shocking, it remains in line with historical intra-year declines. Since 1980, despite average intra-year drops of 14.0%, annual returns were positive in 32 of 42 years[i]. Despite ongoing uncertainty, US equities staged a strong late rebound of nearly 9% to end the quarter at -4.6%.
• Within US equities, nine out of 11 sectors suffered losses in Q1 22. Two sectors with positive returns included Energy and Utilities. The Energy sector gained 39% on surging oil prices. Utilities, often considered a defensive sector, also gained 4.8%. Technology-related sectors like Communication Services (-11.9%) and Consumer Discretionary (-9.0%) were the worst performers amid fears of rising rates and a slowing economy. Interestingly, according to Morningstar, Inc., the FAANG stocks contribution to the market’s returns declined from 37% in 2020 to just 2.7% in 2021 (as of 11/19/2021).
• Elevated valuations and rising interest rates hurt long-duration growth stocks. The gap between value and growth stocks across size and style was stark and was significantly in favor of larger and value-oriented segments. Large-cap value stocks outperformed large-cap growth by 8.3%.
• Within international equity markets, both developed and emerging markets fell 5.8% and 6.9% respectively in Q1 22. The conflict in Ukraine weighed heavily on European markets, given its reliance on Russian energy. Additionally, emerging markets, particularly China, struggled as continued COVID-19 lockdowns remained highly disruptive to its economy.
• Bonds had their worst quarter in 20 years[ii]. US bonds fell 5.9% in 2022 as interest rates rose after the Federal Reserve set out on a more aggressive path to tame inflation. Despite higher inflation, TIPS also fell 3% due to rising rates. Longer-term Treasuries, which have the greatest sensitivity to interest-rate changes, were the hardest hit and fell by 10.6%. US high yield bonds fell 4.8% due to the flight to quality stemming from the Russia-Ukraine conflict. Lastly, a stronger dollar and inflation woes also led international bonds lower for the quarter.
• Commodities were the biggest winners as the war in Ukraine fueled further inflationary pressures leading to a surge in oil and grain prices. Gold gained 6.6%, living up to its reputation as a safe haven during the market selloff. Expectations for higher interest rates in the US led the dollar to rally by 2.6%. After a record 2021, US REITs lost 5.3% over concerns of rising costs due to higher interest rates. However, gains were recorded within subsectors such as hotels and offices, as they continue to benefit from easing economic restrictions.
As noted, the past quarter saw significant volatility & turbulence in geopolitics and global capital markets. The outbreak of conflict in Ukraine, resulting in soaring commodity prices, as well as a host of existing cross currents (record inflation, slowing economic growth, central bank policy maneuvers), made this one of the most unpredictable times for investors in living memory.
We are likely (nobody knows for sure) in the middle to later parts of the economic cycle with signs that we achieved peak growth sometime last year. Mid-cycle investing has historically been the most volatile. Add the ongoing concerns of war, supply chain bottlenecks, and an aggressive Fed support that volatility. The good news, perhaps, is that the markets have historically behaved well during periods of rising rates and after times of severe conflict in the world.
Uncertainty has created a market that is very reactionary. The Federal Reserve has turned quite hawkish with minutes from the last meeting showing a determination to aggressively hike rates while shrinking the balance sheet in a concerted effort to curb inflation. Unfortunately, many of the inflationary issues are a product of supply chain issues, fiscal stimulus, and higher energy and other commodity prices driven upwards by the war in Ukraine. Most market strategists agree that the Fed should be raising rates but question whether the hikes should/will occur at the pace and amounts currently laid out. If the path plays out as constituted, it will be the largest and fastest increase since 1994. Taking on inflation through rate hikes brings bad side effects and that is the conundrum facing the Fed. Act too quickly and push the economy into recession, act too slowly (not the current plan), and risk inflation moving higher.
Interestingly, it was June 10, 2020, when Chairman Powell said, “we’re not even thinking about thinking about raising rates.”
We believe that some of the pressure on supply chains will abate later in the year and that we may be close to peak inflation, which could influence the Fed’s data-dependent moves. Peak inflation would be good here but still a challenge given the elevated levels and near-term expectations for a slow fall. Inflation will be a major factor influencing our economic trajectory for now. At some point, consumers and businesses will refuse to pay higher prices. We are seeing anecdotal evidence that businesses with higher input costs, be it fuel or materials, will cease or reduce their operations if they cannot recoup the costs. Consumers ready to travel again may think twice about paying the exorbitant prices greeting them at hotels around the world. So far, demand post-pandemic has not abated but is showing signs of weakness.
This is a multi-pronged problem. Lack of investment in energy structure is coming home to roost. In a recent update, Northern Trust energy specialists note that global capital expenditures on oil mining peaked in 2014 and have been flat since 2018. At the same time, renewable energy sources have not proven to be a reliable substitute to meet the energy demand. Their opinion was that energy inflation will stay constant or move higher over the year as we simply do not have the power to meet the demand at this time.
And what about the yield curve? The yield curve is an oft watched measure of the likelihood of a recession. An inversion of the curve occurs when rates on shorter date bonds exceed those of longer-dated bonds.
This phenomenon has been a good predictor of recession, but it is not foolproof, nor does it clearly define the timeframe that a recession might occur. We saw a brief inversion of the curve last year and for a day or two this year. The growing consensus is that we could see a recession in 2023 if the Fed is unable to balance its moves and inflation proves to be too heavy a burden for the economy. We shall see.
So how are we adapting portfolios to the shifting market environment? What are we doing to navigate the surge in bond market volatility? What can be done to deal with the impact of higher inflation on the markets? These are the questions we have been wrestling with during the quarter. The sands under our feet keep shifting and we have been adapting.
Fixed income markets, as defined by the Barclays Aggregate Bond Index, fell over 6.5%. The 10-year Treasury rate moved from a rate of 1.63% at the beginning of the year to 2.32% at the end of the quarter a very substantial move in a short time period (2). Understanding the headwinds for bonds but not fully expecting the magnitude and speed of the upward move in rates, we had positioned our portfolios in shorter-duration (less interest-rate sensitive bonds), floating-rate bonds (whose rates will adjust upward and provide some protection against rising rates despite having credit risk), and a multi-sector bond fund with a go-anywhere mandate. Municipal bonds were not immune to the rate hikes, and we did see these bonds fall in line with taxable bonds
We have been steadily introducing structured credit and hedged investments into our portfolios over the past year to dampen volatility and take advantage of it. We’ve added positions with more exposure to energy and metals and are close to adding a dedicated inflation hedge position. The gyrations in the market have also provided loss-harvesting opportunities that we are taking advantage of where possible.
For the near future, we see markets trading sideways as we continue to transition away from a disinflationary, low-rate, low-risk premium environment. While the road ahead looks challenging, the importance of diversification is very clear.
Our headwinds/tailwinds summary is below.
• Federal Reserve tightening aggressively
• Inflation (commodity prices) staying high in a decelerating economy
• Supply chain issues and declining labor participation hampering economic growth
• Equity and fixed income valuations are high on an historical basis despite recent pullback
• Elevated corporate and government debt levels offset in part by healthier consumer balance sheets.
• Covid shut down parts of China and has not disappeared from the rest of the world.
• Volatility quite challenging near term
• Strong labor market
• Corporate buybacks are likely to be supportive
• Significant cash on the sidelines
• Healthy consumer and corporate balance sheets
• Earnings expectations are still positive in 2022
The House of Representatives passed HR # 2954 on 3/29/2022 (“Securing a Strong Retirement Act”), now sending the bill to the Senate. The legislation, designed to overhaul the current pre-tax retirement system in the US, includes an expansion of auto-enrollment in retirement plans, an increase in the age at which individuals must begin “required minimum distributions” from age 72 to age 75, and improving the access to employer-sponsored plans to part-time workers.
There has been little movement on bills to increase income tax rates as was very much in focus last year. We will be watching for any updates. President Biden has spoken about a tax on billionaires that is yet to get support. The Tax Policy Center estimates that 57% of US households will ultimately pay no federal income tax in tax year 2021 as pandemic-driven legislation eliminated the tax bill.
PRW’s Chief Investment Officer, Elliot Herman, spoke on two panels this quarter. On February 23rd he served as the Moderator on a panel discussing Alternative Investments for Advisors at the MA RIA Summit. On March 24, 2022, he spoke at the 7th Annual Private Wealth New England Forum, which is the leading forum for family offices, wealth managers, private banks, and asset managers in the region. Elliot was on a panel entitled Best Practices in Wealth Management and Preservation and the panelists discussed changes they have made and the strategies they have stuck with to better protect their client’s money.
We look forward to connecting with you over the coming months. Enjoy the better weather on the way.
William A. Payne
Richard A. Renwick
Elliot B. Herman
(1) Deglobalization is Political, not Economic, Market commentary by Jeffrey Kleintop, CIO at Charles Schwab & Co., April 11, 2022
(2) U.S Treasury
[i] JPMorgan Guide to the Markets. Q1’2022