U.S. Economy: Negative GDP Surprise
The U.S. economy unexpectedly shrank 1.4% in the first quarter of 2022, driven by a drawdown of business inventories and a record trade deficit.1 On the brighter side, personal consumption increased by 2.7% and year-over-year core inflation dropped to 5.2%, the first signal of easing in the past 18 months.
U.S. Stocks: Akin to March 2020
Large-cap stocks fell nearly 9% on concerns over rising interest rates, inflation and a potential recession. While 80% of the S&P 500 companies already reporting earnings have beaten Q1 estimates, consumer bellwether Amazon had its first quarterly loss since 2015 and earnings growth has slowed broadly.
Foreign Stocks: Global Headwinds
Non-U.S. equities slightly outperformed domestic stocks despite the drag of weaker currencies. Brazil and other major raw materials exporters that benefited from the commodities boom were among the weaker performers due to a stronger U.S. dollar, rising U.S. interest rates and their own historically high inflation.
Fixed Income: Rates March Upward
U.S. interest rates continued to rise as the 10-year U.S. Treasury reached 3%, a level not seen since the end of 2018, and bond market losses deepened. Futures market pricing suggests the Fed is likely to raise its key interest rate to more than 3% ultimately (vs. the current range of 0.75% to 1%) to aggressively combat inflation.
Real Assets: Energy Business Booms
Commodities continued to outperform financial markets, although the price of oil finished the month near where it began and gold slumped. While many commodities have soared, other real asset categories have generally lagged but have still provided beneficial diversification from equities.
Alternatives: Macro Strategies Lead
One of the persistent themes of 2022 so far has been hedge fund investments cushioning some of the drawdown in stock and bond markets. Although hedge fund returns overall have not been robust, macro-oriented and managed futures strategies have performed exceptionally well by trading trends in both rates and commodities.
Equities Total Returns
Fixed Income Returns
After a remarkedly strong period for equities between 2019 and 2021, market regime change is now here due to a variety of catalysts, such as COVID-19, supply chain disruption, inflation, interest rates and geopolitics. This new market and economic environment is marked by persistent and jarring volatility, much of it to the downside. Within equities, for example, the tech-heavy Nasdaq composite had the worst start to the year since its 1971 inception, and you must go back to 1939 to find a worse start for the S&P 500.
The latest data suggest the U.S. economy has certainly cooled from the robust pace of 2021. However, we do not think it is teetering on recession (officially defined as two quarters of negative growth). The factors that drove a drop in GDP growth in Q1, such as a 20% surge in imports and lower inventory restocking, are not likely to be repeated in future quarters, and consumer spending (67% of U.S. GDP) is supported by a pandemic “war chest” of $2 trillion in excess household savings, ongoing wage growth in nominal terms and a record level of household wealth.
We are likely to see lower global growth in the near term as Europe bears the brunt of Russian energy sanctions and China’s zero-COVID policy pulls down its growth rate to below 5%. At the same time, central banks in the U.S. and many key economies (except for China) are tightening monetary policy via interest rate increases and decreased bond buying to fight inflation that is now two to three times above the “sweet spot” of around 2%.
While we are starting to see some negative impact of wage and price inflation on corporate earnings, companies may be more resilient than they present. As is typical during times of economic turbulence, corporations appear to be using supply chain travails, geopolitical conflict and China lockdowns to lower analyst expectations for future profit growth – and taking resulting hits to stock prices. From a contrarian perspective, this could be setting us up for positive earnings surprises in coming quarters.
What We’re Doing
Like virtually every one that preceded it, this down cycle has started to shake the resolve of some investors given its four-month grind of volatility—some significant up days and many substantial down days. We’ve even had an extended period where bonds and equities have sold off in tandem.
While the opportunity set in front of us may have shifted due to the volatility we are seeing today, it has not been eliminated. In fact, market turbulence can present opportunities for patient, long-term investors, including owning or incorporating new strategies to take advantage of market dislocations (including via hedge funds, private capital and real assets); tax-loss harvesting to bank loss carryforwards so we can then rebalance to manage risk in a tax-efficient way; and by being a liquidity provider to market segments in which other investors have trouble stomaching the volatility.
High-quality bonds will become increasingly attractive as interest rates rise due to their higher yields, although prices could continue to suffer until rates peak. We are comfortable maintaining a fixed-income allocation that is shorter-term, and therefore less sensitive to interest rates, as a hedge against a significant slowdown in economic activity.
1Bureau of Economic Analysis. “Gross Domestic Product, First Quarter 2022 (Advance Estimate).” April 28, 2022.
Glossary of Indices
U.S. Large Capitalization = S&P 500 Index
Tracks the performance of a representative sample of 500 leading companies in the major industries of the U.S. economy.
U.S. Small Capitalization = Russell 2000 Index
Tracks performance of the 2,000 smallest companies in the Russell 3000 Index, representative of the U.S. small capitalization equity market.
U.S. Growth Equities = Russell 3000 Growth Index
Tracks the performance of those Russell 3000 companies that have higher price-to-book ratios and higher forecasted growth values.
U.S. Value Equities = Russell 3000 Value Index
Tracks performance of those Russell 3000 companies that have lower price-to-book ratios and lower forecasted growth values.
International Equities (Developed Countries) = MSCI EAFE Index
A float-adjusted market capitalization index designed to measure developed market equity performance, excluding the US and Canada. Consists of the stock market indices of these 20 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
Emerging Market Equities = MSCI Emerging Markets Index
A float-adjusted market capitalization index designed to measure equity performance in the major emerging markets. Consists of the following 25 emerging-market -country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
U.S. FIXED INCOME, TAXABLE
U.S. Aggregate Bond = Barclays Capital U.S. Aggregate Bond Index
Covers U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market consisting of SEC-registered securities. Includes U.S. Treasuries, U.S. agency bonds, U.S. corporates, mortgage-based securities (MBS, CMBS) and asset-backed securities (ABS).
TIPS (Treasury Inflation-Protected Securities) = Barclays U.S. Treasury Tips Index
Measures the performance of TIPS of various maturities issued by U.S. Treasury.
INTERNATIONAL FIXED INCOME
International Developed Bonds = BofA Merrill Lynch Global Government Bond II ex U.S.
Measures the performance of non-U.S. developed-market government bonds on an unhedged currency basis.
Emerging Market Bonds = BofA Merrill Lynch Emerging Markets Sovereign
Bond Index Measures the performance of emerging markets government bonds on an unhedged currency basis.
U.S. FIXED INCOME, TAX-EXEMPT
Intermediate Municipal Bonds = Merrill Lynch Municipals, 3-7 Yrs Index
A subset of The Merrill Lynch U.S. Municipal Securities Index, including all securities with a remaining term to final maturity of between 3 and 7 years.
Municipals, Broad Market = Merrill Lynch Municipal Master Index
Tracks the performance of U.S. dollar denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions.
Absolute Return Funds = HFRX Absolute Return Index
Tracks the performance of hedge funds aiming to provide stable performance regardless of market conditions. Such funds tend to be less volatile and less correlated to market benchmarks. Data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month and is subject to revision.
Market Directional Funds = HFRX Market Directional Index
Tracks the performance of hedge funds that add value by participating in the direction of various financial markets. Such funds characteristically have higher expected volatility than Absolute Return strategies (see above). Performance data is based on estimates for the most recent months, may not include performance for the last business day of the indicated month, and is subject to revision.
Equity Volatility = CBOE VIX Index
Aims to measure investor expectations for near-term stock-market volatility as conveyed by the pricing of stock options on the S&P 500 index that mature within 30 days.
Implied Inflation = 10-Yr TIPS Implied Inflation
Gauges investor expectations for future U.S. inflation based on the difference between the yield on a 10-year TIPS (Treasury Inflation Protected Security) and the yield on a nominal 10-year Treasury.
Gold Spot $/oz.
An index intended to measure the current price of gold, based on futures contracts deliverable in the following month priced in U.S. dollars per Troy ounce.
Oil = Brent Crude Oil Spot Price $/bbl
Brent Crude Oil refers to a particular grade of crude oil often quoted in financial reports as the global benchmark for the price of oil. It typically trades at a premium to the West Texas Intermediate price.
U.S. Dollar = Trade-Weighted U.S. Dollar Index
Value of the U.S. dollar relative to a composite of 26 currencies of major U.S. trade partners, weighted based on trade data.