Quarterly Review - Q1 2022 Inflation: Getting Too Much of What We Need

SUMMARY

• Both stocks and bonds struggled in the first quarter due to inflationary pressures.

• Commodity linked sectors and countries benefitted the most, while growth assets and commodity importers struggled.

• The war in Ukraine hurt Europe relative to the rest of the world.

There were three major geopolitical events in the first quarter:

1. Rapid COVID-19 Recovery – increased demand for energy resources which drove up prices
2. The Ukrainian/Russian War – reduced supply of oil and food and further complicated shipping routes
3. Diplomatic Strain with China – slowed logistics in the South China Sea and created supplier uncertainty for companies

Unfavorable resolution of any of these three raise the risk of high inflation becoming structural. This could create low economic growth or even a recession coupled with high inflation – a phenomenon known as ‘stagflation’. Central bankers, governments and markets have a handful of tools at their disposal to try to avoid this. Since the different tools have different time lags to affect the economy, the process will look more like a feedback loop, with the different financial constituents interpreting each other’s actions and reacting in real time. This feedback loop is likely to lead to elevated uncertainty, hence the analogy in our 2022 Outlook of market volatility reminiscent of riding a mechanical bull.

2022 started off with an abrupt shift in the market’s perception of inflation. Over the quarter, U.S. long term interest rates rose 1%, and international rates turned positive after remaining below zero for some time. This increase has yet to show signs of tamping down inflation, but it did produce the first quarter of negative equity returns since the beginning of the pandemic. Fixed income performed as poorly as equities, which provided a challenging backdrop for investors who rely on bonds as a diversifier against negative equity returns. While a rally in equities at quarter-end helped, the S&P 500 (Large US Companies) lost -4.6%. The Bloomberg Aggregate bond index lost -5.9% as a direct result of the increase in rates. Developed International Markets (-6.5%) and Emerging Markets (-7%) performed poorly as concerns about Ukraine took center stage in the second half of the quarter. High yield bonds were negatively impacted both by interest rate increases and credit risk. Cash was the only haven in the broad asset classes we track.

Sector Returns Were a Function of Inflation and Rates

Looking under the hood at US sectors, we see that the only refuge for investors was the energy sector, which led both during the quarter and over the last twelve months. Utilities that have exposure to energy production also benefited. Staples were able to effectively pass on inflation to consumers, and other cyclically oriented sectors (Industrials, Financials, and Materials) were able to keep up with inflation better than growth-oriented sectors (Tech, Comm Services, Health Care and Discretionary). Similarly, Real Estate lost ground due to its reliance on low interest rates in order to finance projects. On a trailing twelve-month basis, Energy has now built a strong tactical lead over the other sectors. Returns are still positive for equity investors over the past year, except for Comm Services, which had several notable earnings misses.

As we move into Q2, there is concern that earnings will begin to slow down; only the Energy sector is currently seeing analyst earnings estimates accelerate (see chart, left). It is natural to see some level of slowdown in earnings revisions coming off a year like ’21, where the economic rebound was so sharp. However, we believe that earnings must continue to grow in order for stocks to finish the year higher. We believe that companies in cyclical sectors now have the wind at their back, and that technology companies will surprise investors with their earnings resiliency in Q2. We are more concerned about the earnings growth of Staples, Health Care and Utilities in this environment, due to rising input prices.

International Returns Also Related to Inflation, Rates, and Geopolitics

International Country Selection came down to two factors this quarter, in our view. Countries that are commodity producers (ex-Russia) performed remarkably better than those that weren’t. Latin America benefitted especially from its enviable position as a commodity supplier to China and the United States. Canada, Norway, and Australia similarly benefitted from rising commodity prices, while Europe struggled from Russian geopolitics, and Japan was harmed by the rise in energy costs.

Conclusion

The bottom line is that macro and geopolitical issues in the first quarter led directly to volatility and weakness in both stocks and bonds, which we believe makes getting a handle on possible inflation outcomes critical for the rest of 2022. In our upcoming Weekly View, we will flesh out the most likely scenarios, their implications for different asset classes, and how we are positioning portfolios.