Quarterly Commentary Q1 2022: Inflation, Interest, and Stocks
This report includes current and past portfolio returns and current positions as of March 31, 2022.
During the first quarter of 2022, the Russia-Ukraine conflict spurred additional supply chain, energy and strategic metals supply disruptions, further accentuating inflationary pressures.
Higher inflation has resulted in the U.S. and some other countries increasing interest rates, with many more future interest rate increases expected. Higher interest rates raise borrowing costs, which negatively impact many businesses and causes most investment asset prices to decline. A new coronavirus variant surge delayed expectations of a strong post-coronavirus economic surge.
These adverse developments had a large effect on global bond markets. U.S. 20+ year Treasury bonds fell 11.0% in the first quarter. High yield bonds (Bloomberg) lost 4.8%. Emerging markets dollar-denominated bonds lost 9.3%.
Stocks did not fare much better. The S&P 1500 Growth index and growth stock heavy S&P 500 lost 8.6% and 4.6%, respectively, over the first quarter. The S&P 1500 Value index had a small loss of 0.2%, largely helped by an overweight to energy, materials and staples stocks. Small cap stocks (Russell 2000), foreign (EAFE) and emerging markets stocks (MSCI), declined 7.5%, 5.9%, and 7.0%, respectively. Worldwide stock and bond asset allocation mutual funds (Morningstar World Allocation funds) dropped 3.2%.
A few assets did well in this inflationary environment. S&P energy stocks increased 39.0% during the quarter. The Goldman commodity index and gold increased by 33.1% and 6.6%, respectively.
Looking forward, we expect corporate profit margins to be squeezed by inflationary pressures. The Federal Reserve’s extraordinary stimulus is expected to be slowly dialed back, though it is unlikely to materially detract from economic growth until real (inflation-adjusted) interest rates turn positive—in 2023 perhaps. Companies and sectors that are less commodity, wage and interest rate-sensitive are favored.
Eventually, supply chain issues due to the coronavirus and Russian conflict are expected to ease, which is expected to also result in the rate of inflation declining from recent highs.
In the short-run, a more cautious stance is warranted for stocks and bonds. Hedged and “alternative” assets offer attractive risk-adjusted returns. Holding slightly higher levels of cash is also reasonable. If stocks do suffer another material decline in the coming months, this could be an attractive buying opportunity. Long-duration fixed income assets are still unattractive, though higher interest rates combined with an easing of inflation rates could change the outlook.
As always, please feel free to contact WESCAP at (818)563-5170 or contactus@wescapgroup.com if you would like to discuss any of this further.