April 2022
By Arthur Swalley, CIMA® Partner
The first quarter of 2022 brought seemingly every major category of investment and headline risk to the forefront. Global stock and bond markets were challenged with interest rate risk, stock valuation risk, and inflation risk, with a topping of geopolitical risk (a European land war) adding to the fun! In our view, it’s remarkable global stock markets held up as well as they did, losing only around 5% for the quarter. Bonds, on the other hand, were no safe haven – the Bloomberg Aggregate Bond Index actually underperformed both the MSCI World and the S&P 500 stock indices for the quarter.
Looking at the specific risk factors facing the markets, first up is interest rate risk. The Federal Reserve began raising the short term federal funds rate in March, and signaled an aggressive approach to raising interest rates throughout 2022 to keep inflation under control. The longer term bond markets responded with a rapid wave of selling, moving interest rates to nearly 3% for the benchmark 10 year Treasury bond (many mortgages are priced using this rate). Historically this is still a very low rate, but it is a quick departure from the far lower rates we enjoyed as the government stimulated the economy during the COVID-19 pandemic. We think that as interest rates normalize in response to the strong post-vaccine economic recovery, businesses and consumers will be able to adjust and the economy will be able to continue its growth, possibly avoiding a recession. With higher rates signaling a healthier economy, we see short term interest rate risk and a temporary slowing of growth leading to longer term opportunity through sustainable economic growth.
Stock valuations have been higher than historical averages for many years due to a combination of low interest rates and the rapid earnings growth of large technology companies. Performance has been persistently strong even in the face of the COVID-19 pandemic. In 2021, stocks without earnings peaked out at levels only seen once before – the 1999 tech bubble. Since then, lower quality growth stocks have declined substantially, punishing speculators and trend chasers. Sentiment about the stock market has turned negative and is getting worse, which is often a signal that the overall market is undervalued. We see this short term sentiment risk as setting up another long term opportunity for positive stock market performance.
Inflation is yet another short term risk factor impacting stocks, bonds, commodities, and interest rates. The Federal Reserve is trying to get inflation down by raising short term interest rates, the bond markets are anticipating higher inflation with higher long term interest rates, the stock market is observing the consumer suffering higher prices across the board, and oil and industrial metal markets are surging as the post vaccine demand for goods increase beyond all predictions. Russia’s invasion of Ukraine has added another layer of supply volatility to the oil and metals markets.
Is the inflation we are experiencing in the short term pervasive and systemic, or will it be mitigated the combined action of the Fed, businesses catching up with production to meet demand, and the flames of war cooling? We don’t know the answers to these questions, but there are reasonable odds based on historical precedent that many of these pressures will turn out to be short term in nature, leading to good long term opportunities for patient, disciplined investors.
As usual, we will avoid predicting what will happen to markets for the rest of 2022. Stocks have had a “normal” 10% correction already this year, and bonds are down nearly that much. Market speculators are fearful and jittery. Headline risk – war, dysfunction, and fear – gets more “clicks” and drives short term behavior to poor investment decisions. The noises are loud, but the underlying signals of the economy – innovation, opportunity, and a strong consumer – point to long term opportunities.
We will be watching how the rest of 2022 plays out with great interest!