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Monthly Market Update - April 2022

April 04, 2022

Economic Resiliency or Recession: As the first quarter of 2022 comes to an end, will the central bank orchestrate a soft landing for the economy, navigating war and inflation headwinds? Or will they precipitate a recessionary environment, pumping the brakes on an economic engine already in deceleration?

Russia’s brutal invasion of Ukraine had a much shorter effect on the broad US markets than most would assume, with stocks recovering throughout March, ending the month up 3.6%. Still, the first quarter of 2022 has felt like an emotional roller coaster, not only for investors, but just about everyone. We entered a third year of an exhausting pandemic, with a horrific war and seemingly endless inflation news. The S&P 500 is down 4.62% for the year; the worst quarterly performance since the beginning of the pandemic in 2020. The large cap equity index has rebounded from its low of (12.5%) during the quarter. Developed market European stocks recovered, though not as strongly. Asian and European emerging market equities struggled with China Covid lockdowns and the war, although Latin America has been a bright spot.

Uncertainty remains…

You are not alone if the recovery in market prices feels premature to you or you feel uneasy about things. Despite being in line with historical norms, the swift comeback for stocks flew in the face of more precariousness and bad news. The Ukrainian people’s incredibly staunch defense of their country and Kyiv from Russian aggression, while inspiring to the rest of the world, has unfortunately perpetuated the uncertainty of the war’s outcome and ramifications. The potential long-term effects on the global order, from currencies to supply chains, are manifold and hang in the balance.

At home, the Federal Reserve is contemplating how aggressive it needs to be after even higher inflation reported in last week’s economic data. The March jobs report was adequate, with upward revisions for months past, yet it was the weakest since September and fell short of expectations. The problem with jobs reports is that they are a lagging indicator, and clouds are on the horizon. There may be negative Q1 earnings surprises after such strong reports over the past year.

The US economy by most measures is still robust, but according to the March surveys there was a large decline in hiring plans and new manufacturing orders fell dramatically. Labor participation has long been an issue. We do not have enough labor - or inventory for that matter - to meet the demands of an over-stimulated economy. Employees are typically the largest cost for businesses, and it is starting to hit them hard. Wage inflation resumed, jumping 5.6% from a year earlier, which was the fastest pace since late 2020. Still, the higher income for the average worker is not keeping pace with inflation.

The PCE (Personal Consumption Expenditure) measure, what the Fed monitors most for inflation, was up 5.6% and prices paid for just about everything accelerated. This can become a painful cycle as consumers command higher wages to keep up, until demand finally stalls as more and more goods and services become unaffordable. The White House announced the administration would release one million barrels of oil for six months from the Strategic Petroleum Reserve, the largest in history, to lower oil prices. The price of brent crude dropped 7% on the news, settling at just over 100 dollars a barrel.

The Federal Reserve will most likely have to become more aggressive to blunt inflation, cooling overheated economic conditions. It is truly threading the needle as they play catch up. The key will be to choke off excess demand until enough labor and goods can return after supply chain issues and the Great Resignation (changing employment preferences or folks prematurely exiting the workforce). The faith in this process is waning as calls for faster rate hikes and quantitative tightening become stronger.

On the war front, Russia remains bellicose, though it has been difficult to follow with certainty what Russian President Vladimir Putin’s end game is, or precisely what he is trying to accomplish. There are reports that his highest military advisors are providing him inaccurate information out of fear, which could be behind Russia’s confusing strategy and consistent miscalculations throughout the past month within Ukraine. Kyiv, the capital, is now free from Russian occupation, but has been left devastated. What seems clear is that Putin does not have an issue with killing civilians and destroying anything and everything within Ukraine’s borders. They attacked areas where they vowed to scale back, and everything Russia has said has not tied to their actions.

This uncertainty continues to create volatility in energy and commodities markets, as reports of potential ceasefires come and go. There is hope for a meeting between Ukraine President Zelensky and Putin soon. However, the mostly despised Moscow strongman does not appear to have a clean way out of this. The Russian economy is in shambles, as he has not visibly accomplished anything other than rampant destruction and global mistrust. Sanctions will likely be in place until he leaves or is removed from power.

President Biden spent time in Poland for a NATO summit stating that Putin should not be in power, but that statement was walked back by the White House. The stakes are very high for Biden and Europe – there could be US military intervention if chemical or nuclear weapons are used.

With Fed actions, inflation, and war all potentially contributing to slowing economic growth at home, recessionary risks are on the horizon. However, we are not there yet. The Fed has completed its goal of full employment and then some, with the unemployment rate at 3.6%. Consumers have the strongest balance sheets in more than 30 years in terms of cash and assets relative to debt, despite higher prices.

So, what about the slightly inverted yield curve everyone keeps talking about? Isn’t recession axiomatic when this happens? Not necessarily. We have recently seen inversion at different points on the treasury bond yield curve (when shorter term bond yields rise above longer dated bond yields) which has, in the past, predicted recession around a year in advance.

Yet the focus might be too much on the traditional parts of the curve which may be unreliable predictors now. The five and thirty-year treasury bond yields spread inverted briefly along with the more closely watched two (2.34%) and ten-year yield (2.33%) spread on Friday. The two-year yield is the most sensitive to the Fed’s monetary policy, but the sharp rise in yield is based off the Fed’s anticipated, not actual, moves. The ten-year to thirty-year bond yield range includes the unprecedented effects of quantitative easing.

The Fed continues to hold a massive percentage of long-term bonds which can artificially hold down long-term rates, skewing the overall yield curve. The more accurate spread to watch, given the Quantitative Easing dynamics and current policy might be the three-month to ten-year treasury yields, which has steepened and captures what the Fed has done (a quarter point hike). Real rates are still very negative, accounting for inflation, which is stimulative.

We will closely watch how rates react in the coming months, as we need a consistent inversion and much softer economic data to begin to worry about recession. Financial conditions are quite liquid, and the Fed is accommodating despite the tightening rhetoric. This is all related to the US as Europe will most likely experience some recessionary impact from the war.

When looking at our portfolio positioning, we remain domestically focused on strategies that include quality factors, high dividend, and value style equities. We like the high or growing dividend space where valuations are relatively cheap, cash flow is strong, and can benefit from correlation with rising rates providing an alternative for income-searching bond holders losing portfolio value.

We will stick with inflation and rate-defensive asset classes and sectors as a key component in our portfolios. Funds holding large tech, healthcare, industrials, and homebuilder stocks with cash flows and pricing power help stabilize a portfolio as well.

We include small cap funds for growth which, as a market cap segment, trades cheaper than large caps and will pay the volatility premium. This includes long-term green energy and commodity exposure, which will be important as President Biden is using the defense production act to boost production of minerals for electric vehicle batteries. For bonds, we plan to stay shorter in duration and maturities to reduce interest rate risk from Fed tightening.

It remains an interesting and tricky time for market participants. We will continue to look for hope in the headlines, considering many factors and statistics, both quantitative and qualitative, while staying true to our long-term strategy and investment process. As we’ve entered spring and the 2nd quarter, we are cautiously optimistic for the global outlook. Despite the apparent headwinds, there are always opportunities in the markets, and we will watch closely for them.

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