Recap of 1Q
U.S. equities, as measured by the S&P 500 Index, returned -4% in the first quarter, including dividends. While clearly negative, it certainly marked an improvement from the March 8th low of -13%, having come down from the January 3rd all-time high. Non-U.S. equities, as measured by MSCI’s All Country Worldwide Ex-U.S. benchmark, fell -5.3% in the first quarter including dividends, also a marked improvement from the year-to-date low of -12% on March 7th.
Market drivers during the Quarter
The quarter was a tale of two halves. Prior to Russia’s invasion of Ukraine, all eyes were on the U.S. equity market. Investors were focused on inflation, interest rates, and concerns surrounding the Federal Reserve’s ability to control inflation without driving the U.S. into a recession. Here in the U.S., commodity-oriented and interest rate sensitive stocks (examples of the latter including banks and insurance companies) were performing far better than longstanding leaders in the technology and growth-oriented sectors of the market. As valuations became increasingly sensitive to expectations for inflation and interest rates, it looked as if a material shift in stock market leadership was underway.
Beyond our borders, for the first time in years, international equity markets were significantly outperforming their U.S. counterparts. Years of underperformance, cheaper valuations, higher dividend yields, and far less emphasis on growth and technology-oriented companies in non-U.S. equity market indexes appeared to be the drivers.
However, the trend quickly reversed as Russia invaded Ukraine and investors’ attention shifted, rightly so. Stock prices declined throughout the world – few were immune – and the U.S. market has proven relatively more resilient since the war began.
By quarter end, there was no resolution to the war in sight. In addition, while the Fed has finally started raising short-term interest rates, inflation continues to be a major concern. Wages are rising, which points to at least one part of inflation that will not be transient. Finally, supply chain issues continue unabated and are having a noticeable impact on manufacturing. In spite of these and other factors, global stock markets have recovered significantly from their early March low, yet the near-term outlook remains highly uncertain.
The explanation for why U.S. and international equity markets have recovered from their early March lows is not so clear. We offer some possible reasons:
- Perhaps it is the fact that Ukraine is defending itself far better than anyone predicted, potentially limiting Russia’s ability to wage war beyond Ukraine.
- NATO, along with most of the rest of the world, has unified in a way many thought impossible.
- While the Fed has finally started raising short-term rates, it may not need to raise rates much further if inflation starts to abate as economic growth slows after two years of elevated growth.
However these are all conjectures, and we are hard pressed to see any clear reason why stocks have been climbing in the face of persistent inflation, war, and rising prospects of slowing economic growth.
The reality is, short-term market moves are extremely difficult, if not impossible, to predict. For instance, in 2018 the S&P 500 plunged more than 12% in the fourth quarter when the prior administration surprised the world by starting a trade war with China. Few saw that coming, and the shock threw a wrench in what was looking to be a banner year for stocks. Fast forward to 2020 when the entire world shut down due to COVID-19. The market plunged more than 30% in one month. No one saw that coming, much less the ensuing 60%+ rally, which brought the S&P 500 Index’s 2020 total return to positive 18% for the year, despite the continued pandemic-related chaos that was still very much ongoing at the time. Russia’s invasion of Ukraine and the resulting market fallout is the latest example of how unpredictable the stock market is in the near term.
While we loathe to disappoint our clients, we have no clear answer as to where things go from here for the rest of the year. For this reason, we continually emphasize to our clients the importance of communicating near-term cash needs so we can plan accordingly and avoid needing to sell securities in a down market. Our longstanding approach is to be disciplined when it comes to ensuring each client’s portfolio asset allocation appropriately aligns with risk tolerance, investment time horizon, and other factors captured in the investment policy statement.
Despite our admitted inability to call near-term market moves, we are mindful of the current risks and are paying close attention to the rapidly evolving dynamics across global financial markets. We study these dynamics as they relate to our long-term outlook for equities, because we are intently focused on positioning our clients’ portfolios for the long-term.
Three short, yet turbulent months ago, we stated the following: “We enter 2022 with a constructive long-term outlook for stocks.” Our outlook for 2022 U.S. corporate earnings has since become more guarded in the face of rising inflation. The potential for Fed tightening causing U.S. economic growth to turn negative is certainly a risk we are watching. That said, from where we sit today, we believe the U.S. economy remains in good shape: the job market is very strong; and the U.S. consumer and households are in a solid financial position – even if gasoline prices are a headwind as the summer driving season approaches. These factors leave us cautiously optimistic on the potential for continued U.S. economic expansion, current geopolitical dynamics notwithstanding. As such, the long-term outlook for corporate profit growth remains favorable, which bodes well for the market, as earnings are a key driver of equity returns.
Valuations are the other key driver. From this perspective, the U.S. stock market, as measured by the S&P 500, now trades at nearly 20x one-year forward earnings. This figure compares favorably to 21.5x at the beginning of 2022 and 23x at the beginning of 2021. The decline in valuations over the last year and a quarter makes sense in the context of rising interest rates (and geopolitical tension). Stocks tend to discount the future, and with the Fed clearly signaling its intentions, we are inclined to believe valuations are likely to remain more stable from here, barring any material changes in inflation and economic growth.
In closing, despite the current state of our world, stable valuations and continued economic expansion should bode well for equity markets, even if the exceptional returns experienced in 2019, 2020, and 2021 are less likely to repeat in the years ahead.