True to the proverb, March came in like a lion. As oil prices, interest rates, and geopolitical tensions each climbed higher, market volatility soared and asset prices fell. Fear was so ascendant that it caused the Fed to back away from plans to raise interest rates by 50 basis points and instead settle for just a quarter percentage point. And so, here we are at March’s end, and while the lions can still be heard roaring in the distance, there are some lambs stumbling around.
Amid all the tumult, major U.S. market indices finished the month higher. The S&P 500 finished March up 3.7 percent, while the Dow Jones finished up 2.5 percent and the tech-heavy NASDAQ closed up 3.5 percent (each on a total return basis). This rebound, in the face of perhaps the scariest geopolitical backdrop in more than a decade, is remarkable. After some indices flirted with bear market levels in February, defined by a decline of more than 20 percent, equity asset prices have rebounded strongly off the lows. While the first quarter of 2022 will go down as the first quarter of negative returns since the pandemic bear market, it felt a lot worse a few weeks ago than when it finished.
Curious Cross Currents
While the human tragedy in Ukraine is unspeakable, markets react to geopolitical events in curious ways. On February 24, news reports emerged that Russian forces had begun a “special military operation” in Eastern Ukraine. Immediately, global asset prices first fell, but then rallied hard by the close of that first day. After two additional weeks of market declines on frightening news and chilling forecasts about what had become an all-out war in Ukraine, and with oil having approached $124 per barrel, markets began to behave as if this conflict would have a more nuanced impact on the global economy, and accordingly, asset prices. There is an emerging view that some degree of higher energy costs will help prevent the economy from overheating and could convince central banks not to raise interest rates too rapidly. The yield on the 10-year Treasury, which had widened out to almost 2.5 percent (up almost 100 basis points YTD) has come back in slightly. After all, the cure for high prices is… high prices. The more bearish view is that high energy prices will further fuel inflationary forces even while the economy cools, bringing about a bout of stagflation, for which there is no easy monetary policy cure.
Speaking of monetary policy, it was just two months ago when Fed Chairman Jay Powell indicated that the Fed might be forced to raise rates more quickly to ensure inflation did not begin to impede employment. Fast forward to Powell’s remarks after the most recent Fed decision, and the tune has changed; the employment market is so hot that wage increases are increasingly seen as a bigger threat to price stability than higher prices stemming from supply chain issues. That’s another reason why baseline inflation expectations for the year have continued to creep higher. Just a month ago, the consensus forecast for U.S. CPI increase was about 5 percent—today it is above 6 percent, and the 5-year breakeven inflation rate has jumped from 2.8 percent to 3.4 percent. Yes, inflation is still widely expected to subside, but due to higher wages and higher energy costs, inflation seems likely to fall more gradually than was previously expected.
The trouble with easing inflation is that it feels like monetary tightening. Real interest rates are now at negative 4.0 percent (10-year treasury yields of 2.4% less core inflation of 6.4%). As inflation eventually subsides, the effect on real interest rates will be similar to what happens when the Fed raises rates. The market has been reacting to this tightening with volatility, especially among riskier, long-duration assets. Volatility peaked in early March, with growth stocks suffering significant losses. However, after the Fed slightly softened its stance in response to Ukraine, rates still moved higher but more gradually, and growth stocks staged a bit of a comeback. This is why we tend to view volatility spikes, all else equal, as bullish.
While we have been keeping a close eye on events in Ukraine and on the broader markets in general, we have not made wholesale changes to portfolios. We believe that should the trend toward higher interest rates and higher inflation continue, value-tilted will be positioned well to outperform. That’s because portfolios with a value-tilt tend to perform relatively well in this kind of environment. Sectors such as financials and energy, which tend to be well-represented in value-oriented portfolios, benefit from these trends. Also, when earnings growth becomes more abundant, investors are less likely to chase pricey growth stocks in favor of value stocks that are also experiencing solid growth. Finally, higher rates tend to have an outsized impact on long-duration assets such as long-dated bonds and expensive growth stocks, because those future cash flows must be discounted back to the present at those higher interest rates.
Even though growth (Russell 2000 Growth Index) rallied in the latter half of March, bouncing more than 7 percent off its lows, value (Russell 2000 Value Index) did even better for the month and has outperformed growth by more than 1000 basis points so far this year.
While geopolitical turmoil is unsettling, it is a risk that has already been incorporated in our allocation models. While these specific risks are unpredictable, we know these events happen from time to time in the aggregate and accordingly they are already baked into longer-term expectations regarding overall risk and return.
While we will continue to monitor events in Ukraine and beyond, we do not anticipate much “trading” around the situation. We will maintain an eye toward rebalancing should circumstances warrant.
As always, we will continue to vigilantly monitor inflation, interest rates, geopolitical events and other market factors, and we thank you for your trust.
Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.