The St. Nicholas Viewpoint: 2022 2nd Quarter Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist April 13, 2022
First Quarter Performance Review
Outside of pure commodity-based bets (and that’s indeed all they are – bets), there were no safe hiding places in the first quarter of 2022. Even before the attack on Ukraine, both equity and bond markets were each in negative territory. And, as it turns out, economic uncertainty fears were not the exclusive domain of the United States, with global exchanges dipping into negative territory as well. On the international front, Japan topped all others, falling only 3.4% YTD. Other major international markets got hit a little harder, with developed international (MSCI EAFE Index) and China’s Hang Seng falling close to 6%. Not far behind were Emerging Markets, with the MCSI Emerging Markets Index falling 6.9%.
On the domestic front, the Dow Jones Industrial Average got hit the least, falling 4.1%. The S&P 500 fell nearly 5%, and the tech-heavy NASDAQ took it on the chin harder, falling just over 9%. It’s important to note that the NASDAQ didn’t necessarily fall because tech is a bad sector to invest in, it was more that many of the NASDAQ stocks – certainly some tech included – are more speculative growth stocks with rich valuations. This means that they go up the fastest when times are good, but can fall just as quick when de-risking portfolios is the order of the day. Indeed, many of the bigger established tech companies still have visible growth, and they may actually turn out to be good places to be as the economy slows. By example, two of NASDAQ’s biggest components are Apple and Amazon. Apple was down 1.5% for the quarter and Amazon was down just over 2%…not bad considering some high-valuation names in the index have fallen 50%-75% in a very short window. Finally, while they have gotten little media hype and gone mostly unnoticed, bonds provided no shelter at all, with the Bloomberg-Barclays Govt/Credit Bond Index falling 6.3% – notably more than most major markets.
The Fed and Inflation
As expected (it was pre-announced by the Fed months ago), the Fed made its initial interest rate hike during its March meeting. The Fed Funds rate rose above zero for the first time since 2018, with the new target range falling between 0.25% and 0.50%. This was a widely anticipated and, for the most part, ineffective move from an institution with a very consistent track record of overstaying the prevailing strategy. In simpler terms, they let rates stay too low for too long and/or too high for too long. Remember, it was only last year when the Fed was forecasting their intent to leave interest rates unchanged for “years to come”. My how things change so quickly…
The Fed has not only reversed the leave-rates-alone stance, they have rapidly shifted to a very aggressive hawkish posture. After the token rate increase in March, they announced their intent for six more hikes this year and at least three in 2023. That puts the Fed funds peak rate to 2%-3% by year-end. In addition to the monetary policy rate moves, the Fed has not only ended their bond purchase program, they have reversed that program as well and will now be looking to conduct ‘quantitative tightening’. In other words, the quarter-point rate increases scattered throughout the year are too slow and too small to be effective. The Fed will also attack inflation by reducing available liquidity through a bond-selling program. Just as in quantitative easing where the Fed pumps liquidity into the financial system by buying bonds, quantitative tightening does the opposite – reducing liquidity by selling bonds. Why would they want to do this?
Prior to this year, the Fed would buy bonds from the credit markets. This would have a dual effect – rates would be held down as the supply of bonds decreases amid unchanging demand; and, liquidity would increase encouraging banks to lend that money in the hopes it would be used to fund capital expansion and overall business activity. As we can tell from the surge in prices, this liquidity worked very well for two principle buying activities – homes and stocks. Both real estate prices and stock prices flourished. So, it is not surprising then where the coming rate increases will impact first…real estate and stocks. Selling bonds takes the liquidity away from banks. That means borrowing costs go up as the supply of money declines, and it also means these higher borrowing costs will result in a reduction in spending – both consumer spending and capital expenditures. Less spending (read less demand) against a constant supply of goods puts downward pressure on prices. This downward pressure is necessary to fight inflation, and inflation (the Fed’s oft-stated long-term purpose is to control inflation) has become the Fed’s immediate number one concern. Inflation concerns and higher rate expectations are already hitting the stock market, and real estate prices won’t be far behind. We’re not calling for a collapse ala 2008 in either asset class, but there will certainly be continued price declines.
The Equity Markets
Stocks in general seemed to trade on the ‘news of the day’ during much of the first quarter. Unfortunately, this resulted in a very consistent daily price drag on stocks given the political environment in the US, the extremely negative geopolitical environment (particularly surrounding China and Russia), inflation, and the ever-lingering Covid-related concerns. However, we did take solace in the trading patterns leading up to and beyond January earnings reports. We knew that the one thing that could overcome the general malaise of the political world would be earnings, and that is precisely what we witnessed for many of the names that we hold. With few exceptions, most stocks traded down coming into the January earnings reports. Not surprising, earnings were excellent for most of our names, and each respective stock rallied nicely as the realization that earnings growth was continuing began to materialize.
This earnings-induced euphoria turned out to be fairly short-lived. It was evident to most of us that Russia was planning the Ukraine invasion. It was also fairly evident that the invasion would not occur until the conclusion of the Winter Olympics (another politically-charged media negative) given that they were being held in China, one of Russia’s few powerful allies. Sure enough, 4 days after the end of the Olympics, Russia invaded Ukraine. With all due respect to the travesty of any war, that was the end of the earnings tailwind, and stocks began to decline once again.
As luck would have it, some positive outlook revisions and even a couple of meaningless split announcements (Remember, ownership value/percentage/exposure is not changed at all when a stock split occurs) helped a few of our bigger positions fight the downside pressure. The rest of the market, however, clinged to negativity and remains downward-biased through today. Fortunately for many healthier companies, earnings reporting season is upon us once again, and we expect similar positivity and price response from the same companies that experienced it in the first quarter. We’ll add a caveat this quarter however – expect a few more companies (even when reporting healthy earnings) to couch expectations going forward due to unknowns primarily associate with inflation, Russia and Ukraine, and the coming resurgence in yet another Covid strain. Good earnings or no, those companies issuing forward caution will see their stock’s prices continue to fall. In the event they sandbag and overestimate the afore-mentioned impacts, they could see significant rebounds with July earnings announcements, but that won’t stop the angst that will go with yet another difficult quarter.
There is so much media attention given to what’s happening in the equity markets, that the carnage occurring in bonds goes mostly unnoticed. Perhaps ‘carnage’ is an exaggerated descriptor, but fixed income investors are feeling pain as well. Historically, there haven’t been many quarters where stocks and bonds both declined, and bonds ended up taking the bigger hit. Unfortunately, today’s economic outlook is delicate enough that we may see this happen more frequently in the next couple years. The good news is that the bond market now more adequately reflects the six additional rate hikes that will occur this year. The bad news is that it is likely that the expectations reflected in bond prices reflect six quarter-point rate hikes. We think there will be at least two fifty-point hikes, and that may cause bonds to fall a bit more.
In any case, we warned that bonds would not get out of this without downside volatility and that has proven to be very true. The possibility of bonds falling even more this year certainly exists, and any expectations for positive returns for bonds in 2022 should be abandoned. Fortunately for our clients, our fixed income exposure is on the very short side, so our fixed income hit will be less impactive. Remember, bonds have overall less volatility, but that doesn’t mean they always produce positive total returns. Bonds don’t belong in every client’s portfolio, but when we do have bond exposure, we have it for specific purposes – to produce income flows; to reduce volatility; and, to offset risk. Whether a bond’s total return is positive or negative, these are all good reasons to own bonds, and they all provide constructive trade-offs for the lower long-term average returns that bonds typically produce.
We expect the Fed to become much more aggressive in their pre-announced approach to fighting inflation. Yes, they will certainly have six more hikes this year, but don’t be surprised when the next two are fifty basis-point increases. There have been strategist calls that inflation has peaked since Biden errantly declared it as so in December, but we don’t think we’re there yet. Oil prices will continue to be a problem for as long as the Russian/Ukraine war continues, and we should never expect Russian aggression to end quickly when they face determined opposition. Remember, they took nine years in Afghanistan… Still, we are already seeing some price easing in other sectors, so we’ll likely hit an ‘inflation-less-gas-prices’ peak in the next quarter or two. The peak will be in the 8%-10% range, but the average for the next 2-3 years will likely remain in the 4%-7% range. That’s materially above the 0% to 1% we’ve seen over the past several years but it’s still marginally good news.
There are also an increasing number of prognostications that we will avoid recession this year. The argument is that the underlying banking system is strong, capital lending (and thus capital spending) is still on a roll, and the consumer is in for yet another year of Covid-related pent-up demand. This may be true, but it won’t be a boon to all sectors, and our aforementioned reference to a stock-picker’s market will still prevail. We advise investors to continue to focus longer-term. We’ve been spoiled with returns that have been consistently up and consistently positive. Theoretically, it is true that – in the very long term – stocks have indeed always gone up. However, we need to remember that – in the shorter-term – stocks simply don’t work that way. Equity investing can occasionally be a tortuous morass of fits and starts. The irrational and greedy investor typically loses, but the smarter patient investor is ultimately rewarded. Look away for a while if it helps (it does), but remain patient; have faith that the investments we have selected on your behalf will continue to benefit you going forward. That is certainly our feeling, that’s why we started St. Nicholas 18 years ago, and that’s the reason why we’ll keep doing this for years to come.
P.S. We would like to remind clients that all of our written Policies and Procedures are available upon request at any time. We are also required to notify clients of the availability of our regulatory Investment Advisor Brochure/Form ADV and Form CRS on an annual basis, so please contact us at 904-470-0102 with any requests.