First quarter also witnessed the Federal Reserve tapering and ending their monthly bond purchase program, that at one point was buying $120 billion in fixed income. And on March 17th, the Federal Reserve raised Fed Fund Rates for the first time since the pandemic hit. Their 25-basis point hike was disappointing to many that expected to see a stronger move by the Fed.
The biggest headline during the quarter was the Russian invasion of Ukraine. While our initial reaction should obviously be about the humanitarian impact this unprovoked attack has had on tens of millions of people in Europe, it also wreaked havoc on the markets. The United States and our NATO allies have placed harsh sanctions on the Russians, and we’ve supplied the Ukrainians with weapons to defend themselves. Each of you is going to have a differing opinion if enough action was taken. What can be said is the Russian invasion and the subsequent sanctions have caused prices of oil, steel, nickel, lithium, and many other commodities that come from Russia and Ukraine have become extremely volatile and almost impossible to predict. Fears that Russia’s aggression could spread to other ex-Soviet states forced the markets down further, with losses reaching more than 13% intra quarter.
Uncertainty during the quarter spread when Russia threatened to escalate their attacks to include the possibility of chemical weapons and the possibility of nuclear weapons. Some news agencies hinted that the Chinese might use the Russian invasion as an excuse to attack Taiwan, as it would be very difficult for the United States and our NATO allies to defend both countries at once. There were even words like “third world war” used in several publications.
There have been several surprises since the Russians began their invasion of Ukraine. Most military experts have been surprised at the ineffectiveness of the Russian army. They have had logistical issues, their equipment has been breaking down, and they have fully underestimated the resistance shown to them by the Ukrainian people. Most experts would have predicted that the Russians would have overwhelmed the Ukrainian army and after a month of fighting would have taken over the country. As I write this article, the Russians have given up hope of capturing Kyiv, the Ukrainian capital, and are now concentrating on the pro-Russian separatist regions in eastern Ukraine.
The Russian stock market shut down after losing more than 50% of its value due to sanctions and the valuation of the Ruble. The Russian ETF ERUS (chart provided) dropped from $40 a share to $8 a share over a two-week period and stopped trading on March 3rd.
Q1 2022 Market Recap
Commodities were the only asset class that provided positive results for the quarter, up 29.6% for the quarter. Gold reversed its 2021 trend and showed a positive return of 6.84%. The U.S. Dollar continued its upward trend adding another 2.81% to its gains from last year.
The Rest of The Year Outlook
As you can see from the study that we’ve provided, a one percent increase in rates can have a material effect on bond returns. Now imagine tripling these figures. This is what might be on the horizon for bond investors.
Interest rate moves can also have an impact on the stock market, especially for growth-oriented companies. A growth investor buys a company based upon the future expectations of how quickly that company can grow. Higher interest rates can cut into the profit margins of a company. Lower profit margins typically translate into lower earnings growth, which means that the growth investor has overpaid for their investment. If a growth investor buys a company because they believe that the company can grow its earnings by 25% per year and they grow by 20% (which is still great), the investor has overpaid for the stock. The stock will tumble until it finds the appropriate pricing for a 20% per year growth rate, not a 25% growth rate.
A value investor, on the other hand, buys a company based upon what it is doing today. They try to find companies that are underappreciated for what they are doing right now. They appreciate for no other reason than the street realizes their oversight. Increases in inflation have little impact on value companies due to how they are measured. This provides an investor with a much more stable performance during very uncertain times.
The Russians continue to be completely unpredictable. Vladimir Putin appears to be a caged animal who might strike out if he is not provided a way out of his current predicament. There is a risk to world order and to our markets. That said, I think it is unlikely that Putin will escalate the war from here. He has lost more soldiers in the first month in Ukraine than the Soviet Union lost in their entire occupation of Afghanistan. Russia’s decision to end its attempt at taking Kyiv to concentrate their efforts in the east part of Ukraine (where Russian separatists have been fighting since 2014) appears to be the Russians’ way to not lose face. I do believe that the war in Ukraine will end reasonably soon, and when this threat has subsided that the markets will move significantly higher.
We unwaveringly favor dividend-paying companies over their growth peers. As we have shown extensively, companies that pay dividends have historically provided stronger performance than non-dividend paying companies. We would strongly encourage you to weigh your portfolio with our dividend strategies.
Earlier, we provided the impact to bond investors if they experienced just a one percent interest rate hike. We also showed you that Fed Futures point towards Fed Fund rates at 3% when looking out just 15 months. It is a very real possibility that bonds will experience a double-digit loss in the upcoming 12 months. My 10% loss might be conservative. If the stock market provides the same historical return while this happens, an investor would basically break even with the 60/40 allocation and lose 3% with the “more conservative” 40/60 portfolio allocation. In my example I’ve lowered inflation from the 7.9% we are currently experiencing to 5%. In this case, the moderate 60/40 asset allocation would lose 4.5% of its buying power, and the more conservative 40/60
allocation would lose 8%.
We beg you to revisit your exposure to the bond market. Last year the bond market experienced a very mild pullback. Long-term treasuries are already down more than 10% in the first quarter. The aggregate bond index was down almost 6%. This is the beginning of a bear market for the bond market. Please reconsider your exposure, the types of bonds you own, and your duration risk.
While we have experienced a pullback in the stock market, we remain bullish that we can quickly recover these losses and still provide a strong performance for you in 2022.