The first quarter of 2022 was marked by a significant uptick in volatility in both stocks and bonds, in the U.S. and around the world.  And the volatility in broad market indices paled in comparison to the wider swings in individual sectors and securities.  There was no shortage of market-moving headlines in the quarter, the most significant of which had to do with (rising) inflation, interest rates (also rising), and the Russian invasion of Ukraine.  At the lows of the quarter, the S&P 500 entered official “correction” territory, meaning a decline of 10% or more from its peak.  And many growth- and tech-oriented high-flyers did much worse, some falling by 50% or more.  Those hardest hit in the early selloff recovered sharply in March, and the S&P 500 closed the quarter down approximately 4.6%.  International stocks, which outperformed early in the year, collapsed after war broke out in Ukraine and ended the quarter down about 6.5%. 

As for our portfolios and positioning, we fared well relative to our benchmarks in the early part of the quarter.  As inflation rose and higher interest rates became more likely, the hardest hit stocks in the market were high-flyers, where we had little-to-no exposure.  Highly valued growth stocks with little-to-no current earnings, rapid revenue growth, and high expectations came down sharply, while reasonably valued stocks, especially those overseas, did much better.  However, as noted above, the performance advantage we enjoyed owing to our international exposure evaporated once war broke out in Ukraine.  And as stocks recovered some lost ground in March, the very stocks that declined the most in the early part of the year led the way back.  So while we went down less on the way down, we bounced back less sharply as the broader market recovered.  When all was said and done, our accounts, in the aggregate, were down roughly in line with the broader market.

While most of our commentary typically highlights stock market activity, bonds deserve a special mention here, as the magnitude of the moves in both price and yields were unlike anything we’ve seen in decades.  The Federal Reserve’s hand is being forced as reported inflation numbers are exceedingly higher than their officially announced 2% target.  In addition, there are more signs of price increases being sticky, or remaining higher for longer, instead of transitory as the Fed was opining in 2021. 

The yield curve has risen in response to these conditions, especially in short and intermediate bonds.  Two-year U.S. Treasury yields began the year at 0.8% and are currently yielding more than 2.5%.  Ten-year Treasury yields have risen from 1.6% at the beginning of 2022 to over 2.5% as well.  When yields rise, bond prices fall, and year-to-date returns in fairly conservative, high credit quality funds are between -3% and -6%.

With short-term yields rising as much as they have, the bond market is sending a message to the Fed that rates are too low. 

One of the more influential books on our bookshelves here at SoundPath is 100 to 1 in the Stock Market by Thomas Phelps, first published in 1972.  It offers timeless wisdom on stock market investing.  Yet it was the following excerpts about inflation and interest rates that caught our attention as being especially timely, considering they were written in the early part of the last decade to be plagued by inflation and higher interest rates:

One of the most pathetic delusions of our day is the politically popular idea that the government can make interest rates low in a free society while continuing to inflate the money supply.

Logically there is no more reason to think that interest rates are on a permanently high plateau now than there was reason in the 1940s to believe that interest rates then were on a permanently low plateau.  (Actually, many people did believe 25 years ago that interest rates would be permanently low.  Why else would they have bought long-term bonds to yield 2-1/2 percent or less?)

It remains to be seen whether history is destined to repeat itself; however, monetary policy is still extraordinarily loose.  We have long viewed a return to a more neutral stance in Fed policy to be overdue.  And, in fact, we would expect the move from accommodative to neutral to be constructive for the market.  What we don’t know is how persistent inflation will be, or if rates will have to move beyond neutral to get it under control, or if doing so will push the economy into recession.  Our base case, however, is that the Fed will do what it needs to do to combat inflation, and while we expect a “new normal” level for interest rates, we don’t expect a repeat of the 1970s.  If anything, we think a recession is more likely than runaway prices. 

All of which comes back to the question of portfolio positioning.  If you watch the talking heads on business news, it’s always about what should you do now?  What should you own in this environment?  What do you want to own when oil prices, or interest rates, or inflation, are climbing? 

We would remind you that those types of questions are most often asked and answered by people with very short time frames.  Their holding periods are certainly less than a year, in some cases considerably less.  We encourage a different point of view.  If you want to own something for the long-term, you want to own something that can prosper and thrive throughout all phases of the business cycle, not just the current phase.  So rather than focusing on what’s prospering due to current conditions, we’d rather focus on what we can buy at an attractive price because of current conditions that are most certainly going to change in favor of our holdings, given the fullness of time. 

So in an age of resurgent inflation, rising rates, global unrest, supply chain disruptions and deglobalization, we are even more resolute that the best investments for the long-term continue to be financially strong, competitively advantaged, and well-run companies.

As always, please keep us apprised of any changes in your phone numbers, email addresses, home or work addresses, employment status, or any change in circumstances that might impact the way we should be managing your money.

SoundPath Investment Advisors

Eddie Carlisle                                     Doug Muenzenmay                        Julius Ridgway