U.S. equities closed out the quarter with their first quarterly loss in two years mostly due to soaring inflation, the Federal Reserve’s policy pivot and the war in Ukraine. Economic measures of inflation have now reached a 40-year high and are forcing the Fed to make inflation their top priority. Price stability, after all, is their primary mandate. Rising inflation first caught everyone’s attention last April when CPI crossed 4% for the first time in recent memory. Since then, it has ticked higher every month. The most recent release showed CPI has now climbed up 8.5% from a year ago.
Last summer, the government was optimistically describing these higher prices as “transitory”. After seven consecutive months of higher inflation data, the Fed Chair Jerome Powell had no choice but to retire the term by November. Clearly, this is a much deeper problem. As we’ve noted earlier, people experience inflation differently based on what prices are going up and how relevant those are to their household budget. The current inflation data shows these price hikes are driven by energy and food. This affects everyone and is beginning to remind us of the late 70’s.
As we’ve stated before, inflation is the result of too much money chasing too few goods. Usually, one or the other is the culprit, but today we’re getting it on both ends. Blowout spending and quantitative easing over the last two years in response to COVID have increased the money supply at a rate never before seen. This has occurred at the same time as broken supply chains, also due to COVID, have led to shortages in a wide array of finished goods. Anyone trying to buy a car can attest to that. Russia’s invasion of Ukraine at the end of February then became the equivalent of adding fuel to the inflation fire. Commodity and energy prices accelerated even higher as the west imposed strict sanctions on Russia’s economy and central bank.
Rising interest rates had the greatest negative impact on the stock market. Growth stocks underperformed value this quarter. In Q1, the large-cap Russell 1000 Value Index outperformed the Russell 1000 Growth Index by more than eight percentage points, while the small-cap Russell 2000 Value Index outperformed the Russell 2000 Growth Index by more than 10 percentage points. For the large-cap indices, this is value’s strongest outperformance over growth since 2002. The flight-to-safety trade also reversed small and mid-cap outperformance compared to large cap stocks.
Stock performance within the 11 sectors was quite varied as well. 9 of the 11 sectors were down for the quarter. Energy was up an astonishing 39% in Q1 on soaring oil and gas prices while Utilities were up 5%. The rest of the S&P sectors were down between -1% (Financials and Staples) and -10% (Communications and Tech).
At the start of Q1, markets were pricing in three 25 basis point rate hikes for all of 2022. As a result of the inflation outlook, markets are now expecting between eight and nine 25 bps rate hikes. This implies a 2.4% Federal Funds Rate over the next year. The first of these hikes commenced at the March 16 Fed meeting with unanimous consent. The accompanying statement and Chair Powell’s press conference were more hawkish than anticipated, as were the committee’s rate projections. The 10-year treasury has shot up well over a full percentage point this year marking the highest level since December of 2018.
All of these forces are creating a serious headwind for the stock market and they are likely to be a struggle throughout the year. The hope is that earnings growth can keep pace with the higher interest rates. Availability of manufacturing supplies and materials will be the key there. The upside to higher rates is higher yields for income investors. The monetary policies of the last two years have been brutal for anyone seeking income. While higher rates will depress bond prices, for buy-and-hold bond investors such as our clients, we are looking forward to the increased income. This is especially important in light of everyone’s rising living expenses. We’ve already seen improvements in corporate and asset-backed bond yields this month. Roughly half of our current bond holdings are scheduled to payoff over the next three years so our client cash flows should improve with each rate hike. Regardless of what you may hear in the financial news, whatever short-term pain that is felt in the stock market, the long-term benefits of better income will be worth it.