Q1 2022 Review & Outlook
- Elevated volatility is likely to persist in 2022 given uncertainties
- The pandemic, inflation and the Fed, Washington, China, and earnings remain key focus areas in 2022
- Most Sequoia strategies remain generally neutral equities/fixed income, favoring higher quality U.S. and Small Cap equities over International, and lower fixed income duration (interest rate sensitivity) than broad indices
Q1 2022 Review
Investors faced a volatile first quarter to start 2022. The S&P 500 was down -4.60% and our global equity benchmark, the MSCI ACWI IMI was down -5.47%2. The more value-oriented Dow Jones Industrial Average suffered the least of the major U.S. indices down -4.10%, while the more growth-oriented, Tech-heavy NASDAQ was down -8.95%. Energy, Utilities and Consumer Staples led S&P 500 sector performance. Bonds provided no refuge as interest rates surged higher leading to a loss of -5.93% for the Bloomberg U.S. Aggregate Bond Index, marking one of the worst quarters for fixed income in decades2. However, we think the worst may be over for bonds and believe investors should maintain fixed income exposure to hedge equity volatility.
The war between Russia and Ukraine added to existing uncertainties in the first quarter. Beyond the terrible human tragedy, the conflict added to inflationary worries as both Russia and Ukraine supply significant amounts of commodities to the world, particularly to Europe. The price of crude oil, for example, jumped nearly $25 per barrel in Q1 as much less Russian supply met strong global demand, adding to an already tough inflationary environment1. We expect the war will continue to impact this supply/demand imbalance leading to continued volatility with inflation expectations. We also expect continued questioning of the benefits of globalization as major global companies exited Russia quickly after the invasion. This dynamic may lead to further inflationary pressures as globalization has been a major disinflationary tailwind for the last several decades. Clearly inflationary pressure is an important issue we will continue to monitor over time. Most importantly, we are hoping for a peaceful resolution to this unfortunate situation for both the Ukrainian and Russian people.
Outside the geopolitical uncertainties with Russia/Ukraine, we remain focused on the following five key areas:
- The Pandemic: There have been significant surges in Coronavirus cases in China and across much of Asia and Europe in recent weeks4. It seems likely the U.S. will see another spike as well. China has instituted large scale lockdowns to battle the surge. According to the Wall Street Journal, “Since mid-March, more than 70 cities, accounting for about 40% of China’s economic output, have implemented restrictive Covid-control measures7.” The pandemic has been highly effective at disrupting supply chains and thereby increasing input costs for companies. We expect this recent surge to be no different. How these rolling surges are dealt with and how they continue to impact inflation will be an important issue for the balance of 2022.
- Inflation & Fed Policy: The Federal Reserve has a dual mandate of fostering maximum employment and maintaining price stability. The Unemployment Rate is 3.6%, one of the lowest levels over the last 50 years, so the Fed has met this portion of its mandate1. Price stability, however, is another story. The Consumer Price Index is running at 8.5% year over year, the highest reading since December 19811. Consumers, which make up about 2/3 of U.S. economic growth, are concerned about these extraordinary levels of inflation as the University of Michigan Consumer Sentiment Index fell to the lowest levels since 2011 in Q11. As a result, the Federal Reserve has had to quickly change course from viewing inflation as “transitory” for most of 2021 to now projecting significant interest rate increases and large reductions of its balance sheet. This interplay of high inflation levels and a now hawkish Fed has led to substantial increases in interest rates in the real economy. 30-year mortgage rates have increased from around 3% at the start of the year to 4.72% for example1. The yield on the 2-year Treasury has increased from 0.73% to 2.28% this year alone1. Borrowing costs for companies have also increased. For example, Home Depot issued 10-year bonds six months ago at 1.875%1. In March, they issued more 10-year bonds but at 3.25%1. Clearly, the rise in interest rates will slow the economy. The question is how much and how quickly the Fed will have to move to get inflation under control, and how much this will slow the economy?
- Washington: It is a mid-term election year, and, on average, they typically beget more volatility in the markets1. This is just another uncertainty that will challenge us in the coming months. However, there is some good news, we typically see a rally post-election1. Also, while Russia/Ukraine and the Fed/inflation has garnered much of the attention recently, we believe some Congressional action on an infrastructure bill is likely and could be a positive catalyst. Enhanced infrastructure is needed to improve economic productivity longer-term and thereby help combat inflation. Our hope is that Washington can act on infrastructure to help offset other uncertainties.
- China: China’s economy has slowed over the last several quarters1 and is now battling its worst surge in Coronavirus cases since the pandemic began4. The MSCI China Equity Index is down -34.13% over the last year2. The Manufacturers Purchasing Managers Index (PMI) has been bouncing around contractionary territory (50%)1 for several quarters as well. Further, stresses in real estate markets have led several large property developers to miss bond payments1. The real estate market, as with most other nations, is a large portion of China’s economy. For perspective, it is estimated that China spent about 10% of GDP on real estate development in 20205. As we expected, China’s leadership has turned to stimulative measures to support the economy given these headwinds. The PBOC (Central Bank) cut prime loan rates earlier this quarter and the Financial Stability and Development Committee issued a statement in March vowing strong support for financial markets through regulatory relief and packages for real estate developers and technology companies that had been most under pressure1. As the world’s second largest economy, China’s easing of monetary and fiscal measures is likely offering some level of stabilization for global markets as the Fed is occupied with aggressively battling inflation.
- Earnings: Earnings season was stellar again in Q1 as earnings per share grew at 30% and revenues grew at 15% year over year for S&P 500 companies6. The estimated earnings growth rate for Q2, however, is much lower at 5% as companies battle supply chain and wage inflation6. Revenue growth is set to slow to around 11% as well. We will again be focused on what executive teams discuss during conference calls regarding inflation, supply chains, and labor shortages in Q2. Also, understanding how executives view aggregate demand in the US and Chinese economies prospectively will be top of mind. Strong earnings growth was a major tailwind for markets in Q1, but we worry inflation and economic uncertainty may start to erode margins leading to continued volatility for Q2. The Price/Earnings ratio is around 19 times for the S&P 500 while the 25-year average is around 171. The P/E has come in from near 23 times to start the year given the volatility1. Although somewhat elevated compared to its long-term average, we do not view the market as particularly expensive. Any further weakness during the balance of 2022 may provide reasonable buying opportunities for longer-term investors, but all the other economic factors already highlighted will be impactful on both the P and E in the equation.
From our perspective, uncertainty about how aggressive the Federal Reserve must be to cool inflation rates higher than we have seen for decades is likely to lead to more volatility in Q2. We will closely follow whether the Fed will be able to engineer a cooling of inflation through higher interest rates without causing too much economic disruption. The Fed and inflation will have significant impacts on corporate earnings in Q2 as well. All of this, collectively combined with uncertainties surrounding the Russia/Ukraine war, the pandemic, the coming election, and China’s economic growth suggests that investors should brace for continued choppy markets. As forward-looking, discounting mechanisms, financial markets will be parsing and pricing all data related to these key factors. We are still optimistic that the U.S. economy can ultimately weather these uncertainties but think investors should keep expectations in check in Q2 and for the balance of the year.
Most Sequoia strategies remain broadly balanced (neutral) relative to equity/fixed income targets, with an overweight to US higher quality equities and U.S. Small Cap relative to international equities. We have also been targeting lower fixed income duration (interest rate sensitivity) than broad indices. This is the same positioning and conclusions we drew to start the year. Generally, our asset allocation decisions allowed us to perform reasonably well compared to our benchmarks net of fees, while not taking on excessive risk in an increasingly uncertain environment.
Our goal is to provide diversified, long-term focused strategies that fit well into our clients’ financial plans and objectives. We do not believe making sweeping portfolio changes is warranted during volatile market periods. In the current environment, we think it is paramount to be patient, balanced, and disciplined, and recognize that shorter-term volatility often creates longer-term opportunities.
As always, thank you for your confidence in our team,
Asset Management Department
Sequoia Financial Group
Sources: 1. Bloomberg 2. Morningstar Direct 3. Treasury.gov 4. NY Times COVID Tracker 5. https://www.wsj.com/articles/chinas-evergrande-debt-crisis-sizing-up-a-big-mess-11633253402?mod=searchresults_pos4&page=1 6. FactSet Earnings Insight 03/31/22 7. https://www.wsj.com/articles/interest-rate-surge-ripples-through-economy...
The views expressed represent the opinion of Sequoia Financial Group. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Sequoia believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sequoia’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results. Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.