March 2022 | Equity Commentary
Published on April 12th, 2022
We believe the first quarter ended on a positive note, despite all the gloomy headlines. Up until the Russian invasion of Ukraine on February 24, the S&P 500 index had declined -11.3% for the year, but from that date to the end of the quarter, all 11 S&P 500 sectors moved higher and the broad index rallied +7.4%. In our view, the equity market recovery is not a sign that armed conflict is bullish—it isn’t. But the fighting did end the uncertainty weighing on markets about the possibility of war, which allowed investors to assess the downstream effects of the conflict and associated economic sanctions. The sharp correction and partial rebound left the S&P 500 down -4.6% for the quarter, a fairly modest decline, all things considered. Unlike in many other volatile, risk-off periods, bonds were not a reliable hedge against downside equity market volatility. The Barclays US Aggregate bond index finished the quarter with a total return of -5.9%, worse than the S&P 500 index.
In the wake of the war, commodity prices have surged across many different categories. This has already begun to reverberate across the global economy, exacerbating inflationary pressures, contributing further to supply chain issues, and making the Federal Reserve’s task even more challenging. As the conflict wears on, and calls for additional sanctions grow louder, commodity supplies will probably remain tight, exacerbating inflationary pressures on the real economy.
The Covid-19 outbreak in Shanghai may also place some additional pressure on supply chains and inflation in the short-term. As of this writing, most of Shanghai’s 25 million residents are in lockdown, and many factories have been shuttered as officials try to get the outbreak under control. Notably, the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) for China fell to 48.1 in March, a contractionary reading that signals the steepest slowdown since the pandemic started in February 2020. The PMI for Services was even worse, falling to 42.
U.S. inflation reached a 40-year high in February using the Federal Reserve’s preferred personal-consumption-expenditures price index. The index rose 6.4% in February from a year ago, which marked the fastest pace of rising prices since 1982. Even when stripping out food and energy, core prices rose 5.4% year-over-year, signaling that inflationary pressures are broad-based.
This environment has shifted interest rate expectations even higher and has likely contributed to consternation in the stock market. The Federal Reserve raised the benchmark federal funds rate by a quarter point at their March meeting, but Chairman Jerome Powell and other Federal Reserve governors have indicated the Federal Reserve’s willingness—and perhaps even intent—to raise rates more aggressively. 50 basis point rate increases at future Federal Reserve meetings seem likely, as does balance sheet reduction, otherwise known as quantitative tightening. Federal Reserve Governor Lael Brainard, who is awaiting Senate confirmation to serve as the Federal Reserve’s vice chairwoman, said recently that the central bank will start reducing its balance sheet “at a rapid pace as soon as its May meeting,” which notably drove selling pressure in the stock market following her comments.
Changes in interest rates and interest rate expectations have resulted in a flattening yield curve. The yield on two-year Treasury notes briefly moved higher than the yield on 10-year notes, an inversion which many investors view as a ‘flashing yellow’ signal that weaker growth conditions may lie ahead. Yield curves can be measured using interest rates across a wide range of maturities, however, and not all of them are signaling possible recession. The Federal Reserve’s preferred gauge for the yield curve, which compares the yield on the 3-month Treasury note to the 10-year yield, is not inverted and actually steepened in Q1.
While economic headwinds are building and the risk of recession in the future is arguably rising, in our view, the U.S. economy, for now, remains on solid footing. In the latest jobs numbers release in March, U.S. employers added 431,000 jobs with particularly strong hiring in services industries like restaurants and retail. The Labor Department also said that hiring in January and February was stronger than initially reported, signaling that the jobs market is better than most appreciate.
The latest release was the 11th straight month where job gains totaled more than 400,000, which marks the longest stretch of consecutive gains of that magnitude dating back to 1939. The unemployment rate fell to 3.6%, which now puts it very close to its pre-pandemic level of 3.5% (which is also a 50-year low). There are also a historically high number of jobs available in the U.S. economy, which is the opposite of what we would see in recessionary times.
U.S. corporations are also flush with cash and have been investing at a solid clip. According to the “third” estimate released on March 30, 2022 by the Bureau of Economic Analysis, private nonresidential fixed investment – a proxy for business investment – jumped 7.4% in 2021, even when adjusting for inflation. This uptick in business spending marked the fastest rate of increase since 2012. U.S. businesses spent the most on software and information-processing, as the need to ‘digitize’ business operations was catalyzed during the pandemic and is bound to grow as remote work becomes the norm. Spending in this area of IT rose a solid 14% in 2021. We think the trend of ramping up business investment looks poised to continue. Manufacturing firms surveyed by the Institute for Supply Management said they plan to increase investment by 7.7% in 2022, and services firms – which comprise a majority of the U.S. economy – expect a 10.3% increase, as productivity will need to rise in order to offset cost pressures relating to inflation, and in some cases, worker shortages.
As we have mentioned in previous notes, Roosevelt Investments raised cash in our equity portfolios in December and again in February, which we continue holding to cushion the market’s volatility as the conflict runs its course. Our portfolio has recently incrementally shifted into a more defensive posture, adding some positions which we believe are likely to outperform in a weaker economic environment, while shedding others which in our view may be challenged by a weaker environment.
As of March 31st, 2022