Economic Flash: Fed Prepares to Take Action Despite Mixed Signals

U.S. Economy: Seemingly Resilient

U.S. economic data was decidedly mixed in March, with manufacturing activity accelerating, unemployment down to 3.6% and the labor force participation rate reaching 62.4%, within a percent of pre-COVID levels. Meanwhile, home sales disappointed and durable goods orders fell for the first time in five months.

U.S. Stocks: Relief Rally?

U.S. equities managed to claw back a portion of year-to-date losses, with greater clarity around Federal Reserve interest rate hikes and, despite the atrocities, potentially diminished investor anxiety over the war in Ukraine. Utilities (+10%), Energy (+9%) and Real Estate (+7%) were top performers, given persistently high inflation.

Foreign Stocks: Russian Ramifications

Non-U.S. equities lagged as manufacturing activity drooped in Europe, Russia sanctions dimmed the outlook for Japan and a stronger U.S. dollar cut 1.5 percentage points from returns. Meanwhile, Chinese stocks sold off due to rising COVID-19 cases and the potential delisting of notable companies from U.S. exchanges due to auditing deficiencies.

Fixed Income: Yield Curve Inverts

The U.S. yield curve is flirting with inversion, as two-year Treasury bonds now yield the same or slightly more than 10-year Treasury bonds at around 2.4%. Historically, an inverted yield curve has been an early indicator of recession. Still, we are not yet seeing the persistent and uniform inversion that tends to be a precursor to economic downturns.

Real Assets: Energy Boom

Commodities capped off their best quarter in more than 30 years with nearly a 9% gain, as oil and natural gas finished March sharply higher. In response, the Biden administration has pledged to release a record 1 million barrels of crude daily from the nation’s strategic oil reserve and some states are suspending gas taxes.

Alternatives: Showing Their Value

Hedge funds continued to benefit portfolios at a time when bonds are taking a beating. However, performance was disparate across hedge fund strategies. While relative value strategies lagged, equity-based and macro strategies (including managed futures) benefited from the uptick in equities and the surge in commodities, respectively.

Our Take

While January and February offered almost uniformly negative results for investors across asset class, March presented a little more normal give and take. Equities recovered somewhat but bonds continued to decline as investors seemed to refocus attention away from Ukraine and back to inflation and interest rates. However, the two issues are interrelated as the war in Ukraine likely will continue to be a major influence on financial markets.

With the U.S. already struggling with elevated inflation from varied sources, including challenged supply chains and a dislocated labor market, the impact of Russian sanctions will serve to lengthen the duration of the struggle against inflation. Russia is a major exporter of critical goods, including oil and natural gas and key metals used in manufacturing, and Russia and Ukraine, considered Europe’s breadbasket, are both major grain and food suppliers to Europe.

Because supply constraints are likely to persist, the Federal Reserve is combating inflation by raising interest rates to slow down demand. In this, the Fed must walk a tightrope to avoid a recession, given that U.S. economic data is not particularly robust. The inversion of the Treasury yield curve, which is starting to happen now, is one leading indicator of recession that bears watching, although it has never been particularly proscriptive on timing. Although it is not a given., we do believe a recession is now more likely than just a few months ago.

What We’re Doing

We continue to focus our time and energy on the complex task of building and managing well-diversified portfolios at a time of heightened market volatility. At this time, for example, we have portfolio exposures that should continue to benefit from higher inflation, namely real assets. While commodities have performed very well year-to-date, infrastructure and real estate haven’t seen quite as dramatic a runup and offer more compelling valuations, assuming higher inflation proves stickier than we expect.

In recent years, a key concern for us has been whether fixed income would continue to provide the buffer to equity risk that it has historically. The first quarter of 2022 saw bonds post their worst returns in 40 years, and we were glad to have had allocations to cash, real assets, and hedge funds as alternatives to traditional fixed income. Those assets, in aggregate, provided stabilization to portfolios and we anticipate they will continue to do so.

Over the long term, especially if a recession materializes, we expect core fixed income to act as a primary stabilizing lever. But in an environment where interest rates are rising and inflation is high, weak bond performance may persist in the near term. With that said, the flip side of risk is opportunity, as the years of minuscule yields may be behind us and bonds become instruments for income and less so for capital gains.

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