2022 started with a reversal of the broad trends witnessed in financial markets over the past three years. The S&P 500 lost 4.60%, its first quarterly loss since the pandemic’s start in early 2020. While new Covid cases were hitting record daily highs to start the year, they greatly subsided around mid-February. This coincided with a pair of higher-than-expected inflation readings in January and February, both coming in north of 7.5% year over year, the highest levels since 1982. Adding to the pressure on equities was the Russian invasion of Ukraine, as well as uncertainty surrounding the Federal Reserve’s tightening schedule. In the first quarter, energy and utilities were the only two sectors to post gains, with energy returning nearly 40% as oil prices surged on the back of the Russian invasion of Ukraine. Meanwhile, mega-cap tech names like Microsoft, Apple, Amazon, and Alphabet that had been leading equity markets higher over the past few years faded, contributing to the market decline. Higher-growth, lower-profit tech names, such as Tesla, fared even worse amid a notable rotation from growth to more value-oriented companies like Berkshire Hathaway in the quarter. This was evidenced by the 8.94% decline in the tech-heavy Nasdaq Composite Index, while the more value-concentrated Dow Jones Industrial Average saw a narrower decline of 4.10%. Companies with some of the highest valuations were the hardest hit. For example, the ARK Innovation Fund, which is comprised mainly of high-growth, low-earning companies, experienced a 29.92% decline. This was partially a result of the Fed beginning their rate hikes. As interest rates rise, future flows of money, which play heavily into the valuation of the low-profit, high-growth companies, come under pressure as cash flows are discounted at a higher rate. In our view, this correction to the most richly valued areas of the market is positive for the health of markets.
International equities fared worse than domestic equities over the quarter. The MSCI EAFE Index ended the quarter down 5.77% as a combination of the Russia-Ukraine war, global inflation, and rising Covid cases internationally, namely in China, led to a widespread sell-off. A hawkish European Central Bank combined with the largest land war on the continent since WWII led European investors to seek safety and sell equities. Covid began re-emerging in China in early March, and the government locked down several commercially important cities, including Shanghai and Xi’an. This put further pressure on already tight supply chains, threatening to worsen the inflation problem the world is facing, and contributed to the rout in Chinese stocks.
Fixed income had a poor quarter to kick off 2022 as well. A hawkish Fed began raising interest rates for the first time since 2018 and signaled that these rate hikes would continue at every Fed meeting through at least the end of the year. This caused bond yields to surge across the board and briefly led to the U.S. 2-Year Treasury and U.S. 10-Year Treasury yield curve inverting for the first time since 2019. Investors are now pricing in about six additional rate hikes from the Fed for the year, up from an expected three to four at the end of last year. Given the relationship between interest rates and bond prices, the expected tightening schedule pushed the 10-year yield up from 1.51% to 2.33% in the quarter. As far as the balance sheet goes, the Fed ended its bond buying program in March and will soon begin the process of balance sheet reduction, further reducing the demand for U.S. Treasuries.
Before looking ahead, it is important to take note of where we are. The first quarter saw domestic equities post their first loss in two years. Even after falling 4.60%, the S&P 500 has returned over 80% over the prior two-year period. So, while the sell-off was discouraging, it pales in comparison to the impressive gains we have seen accumulate in recent times.
Looking forward to the remainder of 2022, we hold a relatively neutral view of domestic equities. We still expect corporate earnings to continue to rise modestly as Covid continues to fade from the public radar, but the uncertainty surrounding Russia-Ukraine and the Fed’s tightening schedule will likely keep equities from making the same kind of substantial gains we have seen in prior years. We also expect to see some of the value names that have lagged their high-flying growth counterparts continue to make up some ground this year, which in our view represents a healthy broadening of the market.
On the fixed income front, the Fed will continue its tightening campaign by raising short-term rates and tapering the balance sheet. While the Russia-Ukraine and Covid situation in China create increased inflationary pressures, we are likely to see supply chains continue to normalize in the second half of the year. The move higher in yields will also slow the housing market to cool domestic inflation further. In addition, higher yields will increase interest income in bond portfolios and create a more attractive entry point into the bond market relative to recent history.
It is also important to note that Fed tapering results from a strong macroeconomic backdrop. While inflation is at multi-decade highs, the unemployment rate has settled back to pre-pandemic levels, when it was at multi-decade lows. Household savings have hit all-time highs, and consumer spending remains elevated. Peak inflation is usually accompanied by slowed growth, but GDP projections for 2022 remain strong. The current macroeconomic backdrop increases the likelihood that the Fed will be able to tighten without inducing a recession, which they showed was possible during the last tightening cycle. Furthermore, the central bank has no interest in crashing the economy or the market and is likely to be flexible should conditions deteriorate. It is also worth noting that equities have typically fared well during tightening cycles from a historical perspective.
All told, we are looking for the remainder of 2022 to be calmer than the first quarter was but still more volatile than in recent years. While uncertainty remains with Russia-Ukraine, Covid in China, and Fed tightening, the macroeconomic backdrop remains strong. We hope to see some of these uncertainties abate as international pressure wears on Russia, U.S. consumers go out and spend in a less Covid-restricted summer season, and Fed policy further materializes. These factors combine to make us cautiously optimistic about financial markets looking forward to the rest of the year. We have taken steps to best position ourselves and our clients for what the rest of the year may bring, such as shortening duration in our fixed income portfolio and adding to value over growth in our equity portfolio, and we remain on the lookout for opportunities wherever they may present themselves.