The first four months of 2022 have been full of incredible events.
After two years of a global pandemic and everything that came with it, we all longed for some smooth sailing. But of course, the only thing guaranteed in life, beyond death and taxes, is change.
This year has brought war in the Ukraine, rising inflation, and increasing interest rates – and markets have reacted as one might expect through a time of turbulence.
The Markets As a Whole
Q1 represented our first quarterly decline since the precipitous 20% drop in the first quarter of 2020. The first quarter also brought us the highest inflation we’ve seen in the U.S. in 40 years. The fact that the S&P 500 saw only a 5% decline for the quarter actually seemed quite remarkable.
U.S. equities weren’t alone in their decline however. Everything, including corporate bonds, developed foreign markets, emerging markets, real estate, and even treasury bonds, saw a drop in the first few months of the year.
The only places where you may not have seen your portfolio lose ground were treasury bills, gold, or commodities. Commodities actually performed fairly well, but it’s such a volatile area, that we prefer to be cautious rather than aggressive in terms of allocations. Anything that can be up 29% in a single quarter, could easily be down just as much.
Our biggest takeaway from this period of time is that there really wasn’t a risk-off asset that would buffer the downside in the markets. It seems that this drop was determined to find you, with few exceptions, no matter where you had decided to put your money.
The day Russia invaded Ukraine, the market hit a significant low, but then rallied in the days and weeks that followed. Is this typical behavior?
In fact, data going back to 1914 and World War I shows that, with a few rare exceptions, markets have initially reacted negatively to a large conflict, and then generally turn positive in the days that follow.
This behavior is not unusual for the market – when a major event occurs, panic ensues. As investors get used to the new reality, the markets begin to return. This tells us that while global conflict is terrible, it is not necessarily an indication of long-term terror in our portfolios.
Bond Prices and the Inverted Yield Curve
After many, many years of low interest rates and quantitative easing, interest rates have now started to rise. Of course, this impacts the bond market, with massive repricing having occurred throughout this first part of the year.
When it became apparent that the Fed was going to raise rates, the market adjusted, anticipating that change. However, the amount of the increase was likely more aggressive than the market had guessed it would be, and the impact was sudden, creating an inverted yield curve.
An inverted yield curve occurs when short-term debt instruments have higher yields than long-term debt instruments (with the same credit risk profile). It’s unusual and reflects that bond investors are expecting a decline in longer-term interest rates. This is often assumed to be a leading indicator of the R word: recession.
Realistically, an inverted yield curve, while not necessarily a positive signal, isn’t infallible at predicting recessions. Data can be viewed in a variety of ways, and when we’re looking at yield curves, it pays to know which durations we’re watching and comparing. Is it a 3 year duration versus the 10 year, or a 6 month duration versus a 5 year, or some other combination?
It’s best to take data such as this, combine it with data from a variety of other sources, and determine if, together, all of these point in a particular direction.
While there have historically been several situations where an inverted yield curve was followed by a recession, there have also been several situations where an inverted yield curve was not followed by a recession. The differences between those years had a lot to do with other factors in the economy, such as employment numbers, earnings growth, and more.
At this point, the inversion of the yield curve is the only indicator of a potential recession, while other indicators are showing relatively neutral signs. In many ways, the curve is forecasting the easing of inflationary concerns over the long term. What’s important to remember is that while certain individual factors may forecast economic changes, we want to see more than one of them occurring simultaneously in order to start considering taking action.
Politics and Elections
We are about six months away from our midterm elections. With just four exceptions, the last 30 midterm elections since 1900 resulted in whichever party was sitting in the White House losing seats.
On average, midterm years tend to produce the weakest market returns out of all those in the 4 year election cycle. We often see low single-digit returns in equity markets, after which they start to gear up. The third year in the cycle is often the best, with the election year being a little shaky.
Why do midterm and presidential election years produce shaky returns? It’s because there’s uncertainty over what is going to happen, and what the impact will actually be. Once it starts to become clear as to who may end up ahead, the markets tend to rally pretty hard, regardless of whether the results put the power into one party or into a mix of the two. We often see the markets begin to move upwards in the third quarter of the year.
Thanks to our tactical model, we have somewhat managed to stay ahead of the curve, with a fair amount of cash to help us manage through rocky times. As we move through what may be a turbulent year with more change than many would have hoped for after several years of living through historically significant times, we will continue to focus on managing risk while seeking opportunities in unexpected places.
– Greg Stewart, CIO