Living With Uncertainty
Plus Q1 2022 Market Review

The first quarter of 2022 whiplashed investors, with each day bringing a raft of bad news to process. War erupted, inflation soared, bonds tanked, and supply chains were further stressed as rising oil and gas prices smashed into economic recovery. Extreme volatility was the norm: Occidental Petroleum soared 95% in the quarter, while Meta Platforms, Facebook’s parent company, racked up the biggest single-day loss in history for a US company ($232 billion). If you’re feeling unsettled about the markets, you’re not alone.

Russia’s war on Ukraine frayed already fragile supply chains and stoked fears of worldwide oil shortages and deepening world hunger. Global stock markets lost -5.36% for the quarter, dragging down returns for the S&P 500 to -4.6% and ending the index’s seven-quarter winning streak. The Dow Jones Industrial Average lost -4.1% and the Nasdaq Composite lost -8.95%. Excluding the US markets, global stocks lost -5.44%. European and Asia Pacific developed markets gave up -7.37% and -3.11%, respectively, and Emerging Market stocks dropped -6.97%.

Less risky assets were also scorched. The Bloomberg US Aggregate bond index—largely comprised of US Treasuries, highly rated corporate bonds and mortgage-backed securities—turned in its worst quarterly return since 1980, falling -5.93% for the three-month period.

The biggest technology companies, which led returns over the past decade, reversed course in the first quarter. On a relative basis, the S&P 500 outperformed the tech-heavy Nasdaq by approximately 4.35%, the greatest margin since 2008. US Large Cap value stocks outperformed US large Cap growth stocks by 8.30%, the widest margin since 2001.

Anticipation of shortages drove other corners of the market higher, notably energy, food, and commodities. The S&P 500’s energy sector soared 38% to achieve its best quarter in history. Wheat prices climbed 31%, the best quarterly performance since 2010. The Bloomberg Commodity Total Return index gained 25%, its best performance on record.

Bond Market Blues

Investors following the Q1 headlines found plenty to be concerned about in the bond market, generally viewed as a safe haven during times of volatility. Bonds began to look less safe as Fed officials signaled a shift to a more hawkish policy to control fast-rising inflation. The fear for investors is that bonds could underperform cash, and longer-duration bonds could underperform shorter-duration bonds. This could propel them to shift from bonds to cash, or to shorter-duration bonds.

Despite more clarity from the central bank about the direction it is headed, the pace of quantitative tightening is uncertain, and the impact to the bond market is far from obvious.

Even if timing and direction of federal fund rate changes could be perfectly predicted, investors still would not have a complete picture. The Fed is just one of many market participants in a complex adaptive system that impacts yield curves at large. This leaves investors with plenty of questions about how to navigate current macroeconomic trends and interest rate volatility.

Uncertainty compounded the quarter’s poor bond performance and drove investors to pull $87 billion from bond funds in the first three months of 2022. Some 90% of investors are convinced that rates are going higher, so this may seem a logical defensive move. Investors believed that temporary losses would become permanent, and in effect fulfilled their own prediction by turning paper losses into real losses.

The problem with timing is that there are so many ways to err. Over a full interest cycle, a higher federal funds rate could slow inflation and possibly even drive the U.S. economy into recession, which would be more favorable for longer duration bonds than most other asset classes. But who knows? Investors who pulled their money may have an opportunity to reload at cheaper prices.

In minutes from its March meeting, the central bank suggested that it would begin unwinding trillions of dollars in pandemic bond purchases in May. The last time the Fed conducted quantitative tightening, it waited two years after interest rate liftoff to shrink its balance sheet. What if the full effect of quantitative tightening isn’t reflected in current market prices?

Bonds act as good diversifiers in a portfolio. However, the benefits are poor when interest rates are at rock bottom like they were at the start of 2022. While a further fall in bond prices can’t be ruled out, the corollary is that as yields rise, the risk in bonds fall, and their diversification benefit increases.

The sudden leap in bond yields—and drop in bond prices—the likes of which we haven’t seen in decades, is overwhelming bond returns in the short-run. The point for investors is that the initial yield at time of purchase is still the best predictor of future fixed income returns, regardless of the interest rate path along the way.

As it stands, interest-rate derivatives show that investors expect the Fed-funds rate to end the year at around 2.5% and quickly top 3% next year, having only just been lifted by the Fed to a range between 0.25% and 0.5% after starting the year near zero.

Treasuries now yield 2.5% to 2.9% across the maturity spectrum between 2 and 10 years. So, the gap at roughly 38 basis points is nearly 40 basis points lower than where it stood at the end of 2021. With the yield curve flattening, it’s reasonable to assume that shorter-dated treasuries will provide better returns than longer-dated maturities.

What Next?

Who knows what will trigger the next derailment? Inflation, rising interest rates and the economic effects of the war in Ukraine have investors’ attention, but beneath these issues is a muddy brew of other concerns that could combine in all manner of ways to send markets into a tailspin. Among them: a heavy load of developing world debt, stress in the commodity markets, and the lingering effects of the whack-a-mole Covid virus, against which a united strategy seems to have disappeared. Fears of another global financial crisis have been stoked further by Europe’s debt load, China’s slowing economy, potential missteps by central banks, the spread of misinformation, and fears of chaotic elections. And that’s not all. “In the age of constant crisis, the urgent shoves aside the important, which in our case is climate change,” wrote Simon Kuper in a recent Financial Times piece.

We live in a precarious world, and worry over losses have been a fixture of markets ever since the last crisis, Kuper reminds us. But dating back to September 2007, just prior to when subprime mortgages in the US sparked a global financial crisis, the MSCI US Broad Market index has soared over 300%. Capturing those rewards requires discipline, courage, and a commitment to strategy.

The way global markets have navigated the current set of geopolitical and economic problems reminds Mohamed El-Erian (Financial Times, 3-April) of the recurrent “mystery” line in Shakespeare in Love, which he names as one of his favorite films.

Explaining his business to a financial backer, the head of a theatre group notes that “the natural condition is one of insurmountable obstacles on the road to imminent disaster”. When asked, “so, what do we do?” he responds: “Nothing. Strangely enough. It all turns out well.” And when pressed how, he says “I don’t know, it’s a mystery"

Part of the answer to the mystery of stocks’ performance lies in the resilience of the economy,” El-Erian says. The Global Broad Market Stock Index is down 7% YTD but 3% higher than it was since the start of Putin’s invasion. Many find the modest fallout and the lack of broader, more serious reverberations to the global financial system surprising.

Some investors will look to assets such as private equity, which they hope can perform better. Sadly, their hopes are likely to be dashed. Most private equity alternatives focus on illiquid assets. Over the past few decades, the majority of these strategies have not outperformed the public markets. Because these assets are not marked-to-market, their returns look smoother, which understates risk. The drawbacks include high management fees, lack of transparency and hidden conflicts of interest. With so much capital chasing private equity investments, higher initial valuations are virtually guaranteed, leading to lower expected returns.

There is no perfect investing formula, except the one that works for your own personal timeline, risk tolerance, inflation protection, and income objectives. Markets are always unpredictable and sometimes volatile for long periods. We find ourselves in such a time now. Rather than run for cover, adjust your portfolio only as needed to manage progress toward your long-term goals. The workings of the market may be a mystery, but for those who stay in the game, things tend to turn out well over the long-term.

If you have questions about your asset allocation, contact me. I am here to help.

Please click on the following links for the full quarterly summaries courtesy of Dimensional and Avantis. 

Of special interest: "Is it Time to Sell Stocks?" by DFA's Weston Wellington, and "What Happens if the Yield Curve Inverts" from the Avantis team.

Regards,