The ever-increasing inflation and the subsequent economic tightening of the Federal Reserve in response dominated the first quarter of the 2022 market. Surprisingly, the COVID headlines we’ve seen for two years have begun to fade into the background. Unfortunately, that doesn’t mean COVID’s effects on the supply chain have eased: China is still amid a large level lockdown due to COVID. And January saw the Russian invasion of Ukraine, another shock to the markets and the world. The appalling war and the sanctions on Russia served to drive energy prices higher and add to inflation pain felt throughout the world.
On the positive side, unemployment is at a record low and wages have begun to climb. The average worker feels empowered, and employers are holding on to their current employees at all costs. Corporate spending has been a positive contributor to the economy as more businesses reopen and invite employees back to the office. Regrettably, inflation has erased most wage gains, and housing prices moved up this quarter, a statistic suggesting inflation has become sticky and will be more difficult to bring down.
Year to date the S&P 500 is down almost 5%, which is up from the deepest drawdown of 12% in March. The NASDAQ is down 9% with the worst drawdown coming close to 20%. Comparing the S&P 500 Growth and Value Large Cap sectors, Growth is down almost 9%, while Value lost less than 1% YTD. Keep in mind the S&P returned almost 29% last year, so a 5% drawdown was not unexpected and mainly due to Russia’s invasion of Ukraine and Fed tightening. The concern moving forward, however, is how aggressively the Fed will raise rates and what the impact will be on inflation and the economy.
The spotlight is on the Fed in Q2 and probably the rest of 2022, to be honest. Can the Fed bring inflation under control without causing a recession in the process? Considering inflation (US CPI) clocked in at an aggressive 8.5% y/y, it’s safe to say the Fed is behind the curve. Remember, the Fed was still buying Treasury securities up until about four weeks ago. They have only just begun to tighten monetary policy. Until inflation sees significant progress, the Fed seems to have no choice but to tighten up. Because of this, the odds of a recession next year are ticking up.
Moving into Q2 of 2022, we see a challenging market environment. Inflation is here to stay, and we could see anywhere from 5-7 rate increases this year as the Fed continues tightening. Last quarter we moved gains in US Growth stocks to Value, a timely move. We continue to see value in lower-risk equities, underweighting Growth names, and overweighting Value. We believe real earnings (after inflation) will slow in 2022 as slower economic growth, higher interest rates, and higher wages erode profits. Large Cap Value stocks remain historically cheap relative to Growth and provide higher dividends. A combination of high commodity prices and rising interest rates should benefit Value stocks, another reason we prefer Value to Growth. Looking beyond the US, international developed markets will be deeply impacted by Russian energy sanctions; something that could push them into a recession considering current conditions. Current energy prices, along with major COVID illness and lockdowns dues to slow, uneven vaccine distribution have heavily impacted Emerging Markets. We continue to see more value in US markets and have underweighted International and Emerging.
As always, our Wealth team believes your personal goals and investment horizons should be reflected in your portfolio. Your asset allocation should never change based on short-term market projections. We’re always here to help you in 2022 and beyond.
Heather A. Voight, AIF® | Portfolio Manager
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