Global economies continued to rebound from the pandemic in the first quarter of 2022, only to be met with a new round of obstacles. The disconnect between consumer demand and supply chain backlogs persisted, causing inflationary pressure to build. Volatility returned as the Consumer Price Index for March 2022 YoY surged to 8.5%, recording a 40-year high. With the realization that inflation was no longer ‘transitory‘, the Federal Reserve vowed to raise interest rates faster than previously anticipated. This included the first rate hike since December 2018. That, coupled with the Russian invasion of Ukraine, fueled instability and pushed stocks lower and bond yields higher. It is important to remember that is not uncommon for equity markets to trade lower or go through a period of instability at the beginning of a rate-hike cycle.
S&P 500 – First Quarter Performance
The Russian invasion of Ukraine sent essential commodity prices such as oil, wheat, corn, and natural gas higher as the fear of further production and distribution disruptions would materialize. The increase in oil prices alone has been enough to cause investors to connect the dots from higher commodity prices to potential pressure on corporate earnings and consumer spending being the biggest risk to economic growth.
Consumer Price Index – Year over Year Percentage Change
As inflation readings hit multi-decade highs, the idea of the Fed being late in moving to a neutral monetary policy stance (behind the curve) gained traction. The Fed is in a very precarious position, attempting to move more aggressively with larger and more frequent rate hikes to temper the demand side, without forcing the economy into a recession or, worse, a period of stagflation. Whether you are of the belief the Fed is behind the curve or not, the reality is that there are substantial forces behind the more recent rise in prices that the Fed cannot control or influence. Supply chain restrictions, the resurgence of COVID in China, and the war in Ukraine are risks unrelated to the effectiveness of monetary policy decisions.
Fed Funds Rate Expectations
The rise in interest rates had a negative impact on certain sectors within the S&P 500. Investors moved out of more growth stocks (Technology and Communication Services) and into sectors that were more exposed to the traditional economy (Utilities and Consumer Staples). With the surge in oil and natural gas prices, escalated by the Russia/Ukraine war, the Energy sector posted the highest return for the quarter. Those companies with higher valuation/higher growth prospects experienced steep declines at the beginning of the quarter. While some of this could be attributed to profit taking or sector rotation, several large widely-held technology companies posted disappointing earnings results and forward guidance which contributed to general market volatility. Large cap stocks outperformed small cap during the first quarter, which was in line with expectations given the geopolitical climate and interest rate outlook.
Fixed Income Markets
The equity markets were not the only ones to experience a heightened level of volatility during the first quarter. Fixed income markets registered some of the worst performance in years, and long- term Treasury bonds had the worst quarter in 41 years. Most major bond indices declined as investors became nervous over higher inflation, and bonds with longer durations suffered. Investment-grade corporate debt underperformed lower quality, high-yielding debt, indicating investors continue to have an overall positive outlook for the U.S. economy and corporations in general, despite the current global headwinds.
Much has been made of the shape and slope of the U.S. Treasury yield curve of late. In anticipation of increased Fed action, short-term interest rates moved higher relative to longer term rates, causing the yield curve to flatten and, for a brief time, invert (i.e. the yield on the 2-year exceeded the yield on the 10-year.) While the yield curve tends to send somewhat predictable signals as to the direction of economic growth, it is historically inconsistent as to timing. Although it may have a notable track record of forecasting recessions, it cannot predict the length and depth.
While the recent series of events have been challenging, it is important to recognize that the U.S. economy is in a favorable position$ as unemployment remains historically low, the consumer continues to support the economy even in light of higher prices, and corporate and household balance sheets are healthy as a whole. That is not to discount the risks that prevail to the markets and to investment portfolios.
Chesapeake Wealth Management (“CWM”) has maintained the investment philosophy that broad diversification is the most effective strategy during times of volatility. With the abundance of factors influencing the markets, we weigh these events, but focus heavily on the potential long term impact on portfolios and overall financial plans. As with most things, there are conflicting views when it comes to optimal asset management. Modern Portfolio Theory speaks to maximizing overall returns within an acceptable level of risk. Diversification, however, is an essential component of that concept. Historical research demonstrates the benefits of building portfolios on non-correlated assets. And while one might be tempted to overweight exposure to the energy sector and commodities markets due to recent lofty returns, creating a mix which includes exposure to various asset classes, industries, companies and geographical locations has the overwhelming potential - over time – to reduce overall volatility and increase returns.
The idea of achieving superior returns through market timing is another investment premise that CWM does not recommend. The age old adage of “Time in the market beats timing the market” still holds true. Not to get to deep into the weeds, but according to Nobel Laureate William Sharpe, to outperform the market, you have to be correct 75% - 80% of the time. (And the data supports that only about 30% of money managers beat the S&P 500.) Benefiting from market timing means that critical decisions need to be made with great accuracy twice- once to get out of the market at the right time, and once to get back in at the right time- which is an extraordinarily difficult and, for most, an unrealistic act. Again, research shows that a very small number of days account for the bulk of stock market returns over time. Miss any one or more of those outliers, and your return may significantly underperform a strategy with longer term objectives.
Hypothetical Growth of $10,000 invested in S&P 500 – 40 Years
Our overall investment methodology has remained consistent and in light of our longer term outlook, we do make slight adjustments to our process. CWM’s equity process focuses on both fundamental and pricing data. The mutual funds and exchange trade funds are chosen based upon consistent performance, expense ratios and management and asset class exposure. Our fixed income strategy revolves around high quality portfolios, with low duration and below average risk and volatility. While each individual is unique as to their goals and objectives, portfolios are constructed to be more conservative with broad diversification on both the equity and fixed income side.
So, while risks remain as they always do, there are also multiple positive factors supporting markets, and it is important to remember that a well-thought-out and diversified, long-term financial plan can overcome bouts of even intense volatility like we saw in the first quarter. The outlook for markets and global economies is uncertain and changing daily. CWM, however, has a highly experienced team that constantly monitors and evaluates market conditions and potential strategies for our clients as we remain dedicated to our fiduciary responsibilities.
Elizabeth D. Swartz
Senior Vice President/Manager of Investment Services
1. S&P 500 -First Quarter Performance: Federal Reserve Economic Data - Standard & Poors 500 Index, Market Cap Weighted Index.
2. Consumer Price Index: Bureau of Labor Statistics - Average change year over year in the prices paid by urban consumers for a market basket of consumer goods and services.
3. Fed Funds Rate Expectations: Board of Governors of the Federal Reserve System – Market expectations of future Fed Funds Rate.
4. Hypothetical Growth of $10,000: JP Morgan – Growth of $10,000 invested in the S&P500 December 1979 – December 2021.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chesapeake Wealth Management), or any non-investment related content, made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Chesapeake Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing. Chesapeake Wealth Management is neither a law firm nor a Certified Public Accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Chesapeake Financial Group, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.