2022 began with a strong economy and rising inflation.
Real GDP in 2021 grew at a 5.7% rate according to The Conference Board, reflecting a rebound from negative growth in 2020. The invasion of Ukraine by Russia caused economists to slightly lower 2022 estimated growth expectations and exacerbated already-rising inflation. February’s personal consumption expenditures (PCE) price index for the last 12 months was 6.4%, well over the Fed’s target level of inflation. Food and energy prices are a significant reason for the increased inflationary pressure, as is a tight labor market. Supply chain disruptions are an additional factor weighing on growth. The Conference Board is now forecasting a 3% real growth rate for 2022.
Interest rates rise as the Fed accelerates plan to reduce monetary stimulus.
When the Federal Reserve Board finally lifted the Fed Funds rate by .25% in March, it was a widely anticipated move, as rates had already risen. During the quarter, rates for the two-year treasury note rose by 1.55% to 2.28% and the ten-year note rose by .80% to 2.32% as larger future interest rate hikes became more probable. When interest rates rise, the principal value of bonds drops, often leading to negative returns. Additionally, the longer the maturity, the more dramatic the decline in value. Consequently, the broad bond market index, which has an average maturity of 8.8 years, declined by 5.9%. While bond fund returns were negative for the quarter, HTG-managed portfolios have a healthy proportion of shorter-term bond funds which lessened the negative performance. With time, returns typically improve as fund managers add bonds with higher interest rates. Bonds continue to be an important portfolio asset class. Their role is to balance equity market risk by having lower volatility than equities, thereby smoothing overall returns.
Market volatility increases along with uncertainties related to Ukraine, Fed tightening and Covid.
U.S. and International equities were down 5.3% and 5.6%, respectively, for the quarter reflecting the uncertainties of conflict in Ukraine, continuation of the pandemic and the question of whether the Fed can navigate a soft landing, thereby avoiding a recession in the U.S. Stocks at more attractive or lower valuation levels, known as “value stocks”, outperformed those of more growth-oriented companies by a wide margin. Volatility levels increased and at its worst point in the quarter the S&P 500 index dropped 13% from its peak before ending the quarter down 5.3%.
The best strategy in uncertainty is to spread risk broadly.
Uncertainty always exists, but there are times like now when it seems there is more than the usual level of uncertainty. Research has taught us that markets cannot be reliably predicted. Thus, to protect against uncertainty, both known and unknown, the time-tested best practice is to broadly diversify risk.
