Plum Street Advisors
2022 Q1 Commentary
Global markets declined in the first quarter of 2022 across most asset classes. During the quarter, the headlines were dominated by two significant news items. The first was the increase in inflation and interest rates. The second was Russia’s invasion of Ukraine. Of the two, the Russian invasion was the bigger world news story, but the spike in inflation had more direct and immediate market impact.
It may seem surprising that we would argue that the war wasn’t the bigger market story this past quarter. It certainly was more important, as far as the humanitarian crisis, global destabilization, and possibly even marking the end of the “peace dividend” that has supported global trade. The stock market, however, tends to be more narrow in its focus. Investors care primarily about corporate earnings and interest rates (which help determine what a dollar of earnings years from now is worth today).
In that sense, the war between Russia and Ukraine had relatively little direct impact on global stock market value. As of year end 2020, the market value of Russia’s companies was $281 billion (and Ukraine was smaller). By comparison, Apple by itself had a market value of $2,256 billion and the US market had a total value of $41,925 billion. So a decline in the value of Russian and Ukrainian stocks doesn’t impact diversified stock portfolios very much.
Of course, there are secondary effects like the increase in oil prices from a decline in Russian and Ukrainian supply, but for now the markets seem confident that this shortage can be made up in the longer run (as evidenced by lower oil prices for future delivery). If the war drags on or expands, and global impact spreads, it may end up having a greater impact in future quarters.
The final evidence that the war had less impact this quarter than might be expected? The S&P 500 was higher at the end of the quarter than it was in the days and weeks before Russia invaded.
On the other hand, rising inflation and interest rates have had a corrosive impact on both stock and bond markets this quarter. The interest rate on the 10-year Treasury Bond rose from 1.5% at the beginning of the quarter to 2.3% at the end, leading to a 6% decline in value in the Bloomberg Barclays Aggregate Bond Index – the largest decline in bond values since the 1980s. Stocks also declined as rates went up, with the S&P 500 falling 5% over the quarter.
Despite the negative impact of inflation on stock prices this quarter, underlying US corporate earnings are on track for continued strong growth into 2022. Overall, S&P 500 first quarter earnings are expected to outpace the first quarter of last year by 6%, and for the year, 9% growth in earnings are anticipated over 2021. S&P 500 earnings are being led by the energy sector which is estimating a whopping 69% growth in earnings in 2022 over 2021 due to soaring oil prices.
The first quarter saw investors change their preference from growth stocks, such as Apple, Google, and Microsoft, to favoring steadier value stocks like Occidental Petroleum and Nucor. Last year, technology stocks, and growth stocks overall, saw significant gains as the Russell 1000 Growth Index gained 28% (compared to 25% for the Russell 1000 Value). This year, value stocks have held up much better in the downturn. The Russell 1000 Value Index was down less than 1%, while the Russell 1000 Growth index was down over 9% (it is often the case that value stocks fall less during a major market downturn).
International stock returns trailed US stock returns slightly, with the MSCI EAFE index of developed market international stocks declining 5.9% compared to the US S&P 500 index decline of 4.6%. The MSCI Emerging Markets Index declined 7% for the quarter, with the Eastern Europe component of the index (which includes Russia) down 78%.
The Federal Reserve started the process of raising interest rates to combat inflation. On March 16th it approved a 0.25% rate hike, the first increase since December 2018. Fed officials also indicated that they plan six more rate hikes this year as they sharply increased their outlook for 2022 inflation from 2.7% (at their December meeting) to 4.1%.
The 10-year Treasury rate ended the quarter at 2.3%, as mentioned above, up from 1.5% as of the start of the quarter. It had been as low as 0.5% at the low point in 2020.
Bond returns were negative across the board in the first quarter. The Bloomberg Aggregate Bond Index declined 5.9% and the Bloomberg Global Bond Index fell 6.2%. Shorter term bonds tend to be less volatile, but still declined 2.5%, and Treasury Inflation Protected Bonds also held up better than bonds overall, but still fell 3.0%.
For bonds, which tend to be much less volatile than stocks, this quarter was the worst decline in the Bloomberg Aggregate Bond Index since the 1980s. Not only did interest rates rise sharply, but they also rose from a very low level, which tends to exaggerate the price effect.
Last quarter, we said many commodities had not yet responded to the inflationary signals in the market. That changed rapidly this quarter, significantly hastened by the Russia/Ukraine war. The price of oil increased by 33% (from $75.21 to $100.28) during the first quarter. Other commodities also gained, although not as meteorically as oil. Gold gained 7.6% for the quarter.
With inflation roaring ahead, it is interesting to review which assets tend to do better in rising inflation environments.
Certainly commodities and other “real” assets tend to hold their value. For example, gold has done well so far this year, as we had forecast in our commentary last quarter. Oil has done particularly well, and it is often a contributor in inflationary periods.
Bonds generally do poorly in rising rate environments (because they mostly have fixed interest rates), but inflation-protected bonds adjust their value for realized inflation, and hold up better in periods of unexpected inflation. Also, shorter-term bonds do better, as they have more of an opportunity to reinvest more quickly at the higher prevailing rates. In the end, for long-term savers, higher interest rates will actually be beneficial (as long as inflation remains under control).
Stocks are more mixed as they face challenges with inflation in the short term. Growth stocks tend to do worse because their returns are far in the future and a future dollar is worth much less during inflationary times. Value stocks do better, because they have earnings today, and they include banks which can earn better interest spreads as rates rise. Still, many companies may see margins suffer until they have a chance to pass on their higher labor, capital, and material costs to the end consumer.
In the end, it’s difficult to forecast inflation. Remember the idea that inflation was “transitory” last summer? Therefore, a portfolio that has taken into account various potential risks is often the safer bet. As we said last quarter, we believe our investors are best served by holding a diversified portfolio of various stocks, bonds, and commodities, and staying the course over the long run.