Time to come down from the sugar high…
April turned out to be a surprisingly bad month for investors as nearly all corners of the markets posted declines. Although the stage was set for continued headwinds, the breadth as well as the magnitude was more than our initial expectation. In our opinion, what primarily drove these declines were two surprises that caught most investors off guard:
First, inflation came in higher than expected for March at 8.5% in year-over-year growth. Some of this was anticipated as the run-up in fuel prices due to the Ukrainian conflict has impacted all of us at the pump and in heating our homes. Additionally, the combination of continued supply chain issues and a highly competitive, tight labor market has translated to higher costs for many of the goods and services that we regularly purchase.
This, in turn, has begun to build fear in the minds of investors that the Federal Reserve or “Fed” is even further behind in managing interest rates. As a result, the Fed could be forced to raise rates faster than the expectation of 0.25% to 0.50% rate per each meeting in 2022. Due to March’s inflation report and other economic data points, this expectation moved to increases of 0.50% per meeting and ultimately there was speculation that a few 0.75% rate increases were also on the horizon.
Second, economic growth as measured by Gross Domestic Product (GDP) saw a decline of 1.4% in real terms for the first quarter. While on the surface this may seem like a more concerning datapoint than the inflation surprise, the details of this decline should alleviate concerns. The two components that contributed the most to this decline were related to trade and government spending. On the trade front, it is not a surprising decline as supply chain issues have been a headwind for more than a year and companies are laser focused on getting products into their customers’ hands instead of rebuilding depleted inventories. On the government spending side, with the Pandemic appearing to wind down and many of the support programs tapering or ending, its also not surprising that government spending is notably lower than last year’s levels.
The bright spot in this initial report for the first quarter is that personal consumption (i.e. the U.S. Consumer) was up 2.7% in the first quarter. In our view, this shows that the core of the U.S. Economy is continuing to grow and that the “noise” around government spending and trade/business inventories is just a distraction from the decent performance at the core of the economy.
On the positive side of the ledger, corporate earnings were fairly robust for the first quarter. As of publication of this letter, nearly 90% of the companies in the S&P 500 Index reported earnings. At a high level, the United States’ private sector did well with revenues or sales climbing 14% and earnings growing more than 9%. This translates to outperforming analyst expectations by 2.4% on the sales side and more than 5% on earnings.
What is more impressive is the breadth of the report. Every sector in the S&P 500 Index grew and this growth was at a faster pace than analysts were expecting. Similarly on the earnings side, all but two sectors saw their profits grow and only one sector (Consumer Discretionary) failed to meet analyst expectations.
In our view, this strong performance, in addition to cautiously optimistic outlook from many of the companies in the S&P 500 Index, leads us to believe that the U.S. economy is not falling into a recession. Additionally, the fact that company revenues in aggregate are growing faster than inflation also shows that many companies are able to grow while also passing on higher input costs to their consumers. Lastly, the ability for companies to grow their earnings during a period in which U.S. GDP contracted also confirms that the core of the U.S. Economy is relatively healthy, despite the current downturn in equity markets.
This leads us to the most common question we have heard this month: “What should we do in the current environment to protect our investment portfolio?”
The answer to that question is a change from what has worked since the Financial Crisis more than a decade ago: be targeted with your portfolio’s investments. Until recently, just having broad exposure to the markets generated outsized returns for investors. The trend for 2022 has clearly been a shift from broad exposure to areas that have historically been less impacted by rising interest rates. For bonds, this means staying shorter in duration and lower in quality. For stocks, this equates to large companies with dominant positions in their industry and strong cash flows.
In the meantime, we view any weakness in the markets as a result of investors and economies coming off the “sugar high” from historic levels of stimulus and not the start of a deep recession.
Chief Investment Officer, f3Investment Management
Risks and Disclosures
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Asset class risks
Bonds: are subject to market, interest rate and credit risk; and are subject to availability and market conditions. Generally, the higher the interest rate the greater the risk. Bond values will decline as interest rates rise. Government bonds are subject to federal taxes. Municipal bond interest may be subject to the alternative minimum tax; other state and local taxes may apply. High yield bonds, also known as “junk bonds” are subject to additional risks such as the increased risk of default. Debt securities may be subject to call features or other redemption features, such as sinking funds, and may be redeemed in whole or in part before maturity. These occurrences may affect yield. Like all bonds, corporate bonds tend to rise in value when interest rates fall, and they fall in value when interest rates rise. The longer the maturity of the bond, the greater the degree of price volatility. If you hold a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest rate risk or market risk), because you will receive the par or face value of your bond at maturity.
Stocks of Large Growth and Value Companies: Portfolios that emphasize large and established U.S. companies may involve price fluctuations as stock market conditions change.
Stocks of Small- and Mid-Capitalization Companies: Tend to involve more risk than stocks of larger companies. Investments in small- and mid-sized corporations are more vulnerable to financial risks and other risks than larger corporations and may involve a higher degree of price volatility than investments in the general equity markets.
International/Global lnvesting/Emerging Markets: International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging markets.
Commodities: Commodities are assets that have tangible properties, such as oil, metals, and agricultural products. An investment in commodities may not be suitable for all investors. Commodities may be affected by overall market movements and other factors that affect the value of a particular industry or commodity, such as weather, disease, embargoes, or political and regulatory developments. Commodities are volatile investments and should only form a small part of a diversified portfolio. Diversification does not ensure against loss. Consult your investment representative to help you determine whether a commodity investment is right for you. Market distortion and disruptions have an impact on commodity performance and may impact the performance and values of products linked to commodities or related commodity indices. The levels, values or prices of commodities can fluctuate widely due to supply and demand disruptions in major producing or consuming regions.
S&P 500 Index: is a capitalization weighted index that is generally considered representative of the U.S. Large Cap market. It consists of 500 of the leading large cap U.S. companies.
Dow Jones Industrial Average Index: is a price weighted index that is generally considered representative of the U.S. Large Cap market. It consists of 30 blue-chip stocks that are generally regarded as the leaders in their industry.
NASDAQ Composite Index: is a capitalization weighted index that is generally considered representative of the U.S. Technology market. It consists of all three tiers of the NASDAQ: Global Select, Global Market, and Capital Market.
Russell 2000 Index: is a capitalization weighted index that is generally considered representative of the U.S. Small Cap market. It consists of 2,000 of the leading small cap U.S. companies.
MSCI EAFE Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance of developed international markets. The EAFE region includes developed market countries in Europe, Australasia, the Far East, and Israel.
MSCI Europe Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance of European developed markets.
MSCI Japan Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance of the Japanese market.
MSCI Emerging Markets Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
MSCI China Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance of the Chinese market.
Bloomberg U.S. Aggregate Bond Index: is a broad-based flagship benchmark that measures the investment grade U.S. dollar denominated, fixed-rate, taxable bond market. The index includes Treasuries, government-related and corporate securities, Mortgage-Backed Securities or “MBS” (agency fixed-rate pass-throughs), Asset-Backed Securities or “ABS”, and Commercial Mortgage-Backed Securities or “CMBS” (agency and non-agency).
Bloomberg U.S. Government Bond Index: consists of the U.S. Treasury and U.S. Agency Indices. This index includes U.S. dollar denominated, fixed-rate, nominal U.S. Treasuries and U.S. agency debentures (securities issued the U.S. government owned or government sponsored entities, and debt explicitly guaranteed by the U.S. government).
Bloomberg U.S. Municipal Bond Index: covers the U.S. dollar denominated long-term tax-exempt bond market. The index includes four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
Bloomberg U.S. Corporate Bond Index: measures the investment grade, fixed-rate, taxable corporate bond market. The index includes U.S. dollar denominated securities that are publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.
Bloomberg U.S. Corporate High Yield Bond Index: measures the U.S. dollar denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating from the ratings agencies (Moody’s, Fitch, and S&P) are Ba1/BB+/BB+ or below. Bonds issued from an emerging market country are excluded from the index.
Crude Oil: is represented by the generic front month futures contract for West Texas Intermediate (WTI) crude oil.
Gold Spot Price: is represented by the current spot price of one Troy Ounce of gold in U.S. dollars.
Inflation: is measured by the year-over-year change for the Consumer Price Index or “CPI”. This index represents the changes in the prices of all goods and services purchased for consumption by urban households. User fees (such as water and sewer) and sales and excise taxes paid by consumers are also included.
Fed Funds Rate: is the target interest rate set by the U.S. Federal Reserve (Fed) or “Central Bank”. This index reflects the Fed’s efforts to influence short-term interest rates as part of its monetary policy strategy. The index value is calculated by using the midpoint of the Fed’s rate policy when they target a rate range (i.e. 0.25% - 0.50%).
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 Measured as Year-Over-Year growth for the Consumer Price Index (CPI). Source: Bloomberg.
 Source: Bloomberg. “Real GDP” is calculated by actual economic growth (i.e. Nominal GDP) and then adjusted for inflation to represent actual growth of the economy and not just rising values as a result of inflation.
 Source: Bloomberg. 442 out of the 499 companies that are currently in the S&P 500 Index.