Global Commentary Q1

U.S. equities returns were negative during Q1 2022 despite a positive return in March [i]. Value outperformed growth led by the strength of the energy sector and large capitalization stocks outperformed small caps stocks[ii].   Fixed Income suffered as a result of the rapid increase in interest rates, to finish the first quarter with negative returns[iii]. Currently, we feel that it’s a macro-driven environment with a focus on energy, natural resources and interest rates.  While the pandemic is the root cause of these market headwinds the Russia-Ukraine war has accelerated them.

U.S. Equity Markets

The stock market started the year at an all-time high[iv]. The Price-to-Earnings (PE) ratio of the S&P 500 was 21.5x[v], the Fed balance sheet ballooned to over $8 Trillion[vi], inflation (as measured by the Consumer Price Index (CPI)) was well over 7% annualized[vii], and the Fed shared plans to start raising interest rates and shrinking the balance sheet[viii].  Given this backdrop, the U.S. equity markets sold off with the S&P 500 down 13% at one point before recovering[ix].  Through this turbulence, large cap stocks outperformed small cap stocks, and value outperformed growth. Russell Growth index returns ranged from -8.29% to -12.58% and the value indices posted returns ranging from -0.14% to -2.40%[x]. The energy sector, driven by oil, was up 39% for the quarter[xi].  Other value sectors such as utilities and consumer staples provided a safe haven for investors[xii].

While there are market headwinds, including the Russia/Ukraine war, inflation, Federal Reserve tightening and China’s recent round of COVID lockdowns, we believe there are reasons to be optimistic.   The consumer is in a good shape, labor markets are tight, wages have been increasing[xiii] and home values have appreciated[xiv].  Corporations are also in a good shape with hefty cash balances that can be used for stock repurchases, M&A activities and capital expenditures[xv].  We expect capital expenditures in the energy sector in the coming years – with increased spending in almost every category of non-fossil energy[xvi].  In addition, we expect that there will be capital expenditures to improve capacity, ease supply chain bottlenecks and build out U.S. based manufacturing capabilities[xvii].  We believe that U.S. value-oriented equities look relatively attractive because of the impact created by higher interest rates, inflation and geopolitical unrest.  Consensus estimates for the S&P 500 are for 9% earnings growth in 2022, but with lower valuations as multiples have contracted.[xviii] The forecast for the U.S. economy is 3% GDP growth in 2022[xix].

Oil/Commodities

For years oil companies have under invested in exploration and production to focus on sustainability and returning cash to shareholders[xx]. This, coupled with increasing global demand, has created a supply imbalance. As a result, oil prices accelerated from $75 per barrel to $92 per barrel before the Russia/Ukraine war started[xxi].

The Russian invasion of Ukraine at the end of February has further escalated the supply imbalance.  Russia is the world’s third largest exporter of oil, after the U.S. and Saudi Arabia. A large portion of Russian oil and natural gas is supplied to Europe[xxii][xxiii].   U.S. and U.K. have sanctioned all energy products from Russia and many shipping companies are refusing to transport Russian oil[xxiv]. [xxv].  As a result, the price of oil climbed as high as $123 per barrel before retreating to $101 per barrel by quarter end[xxvi]. Russia and Ukraine are also large producers of natural resources and agriculture products[xxvii]. Other commodities have been impacted in a similar way. The war has accelerated shortages and caused the already high prices of copper, aluminum and nickel spike further[xxviii].

Inflation

We expect inflation to be persistent for the next couple of years.  Beginning in April of 2021, inflation started to climb due to supply chain issues and rising energy and natural resource prices. In addition, wages and rents increased significantly, which we believe will have a more permanent impact on the markets.  The February Consumer Price Index (CPI) reading was 7.9% annualized[xxix] and we will see the March reading soon –which we expect will be much higher due to the Russia-Ukraine war.

Fed and Interest Rates

At the beginning of the year interest rates started increasing as a result of market activity. This increase likely signaled the Federal Reserve was slow in acting to combat rising levels of inflation[xxx]. The 10-year Treasury bond yield went from 1.5% at the beginning of the year to 2.32% by quarter end[xxxi]. A large move in interest rates is negative for bond performance, and as such, treasury bonds had their worst quarterly performance since 1973[xxxii]. At the March Fed meeting, the Fed Funds rate was raised by 0.25% the first increase since 2018[xxxiii]. General consensus is that the Fed will raise interest rates seven times in 2022 with potentially 0.50% increases at the May and June meetings[xxxiv].

The front end of the yield curve (0-3 years) has steepened to reflect the near-term pressure to stabilize inflation, while longer dated parts of the curve have flattened or become inverted[xxxv]. Generally, an inverted yield curve signals recessionary pressures; an inverted curve typically precedes a recession by 12 to 24 months[xxxvi].  Through early March equity, markets sold off due to the combination of pressure created from rising interest rates and geo-political uncertainty.

Russia-Ukraine War

As a result of the Russian invasion of Ukraine on February 24th, global financial markets have experienced increased volatility. Russia is the world’s 12th largest economy and a member of the G20[xxxvii].  As generally believed, Russia invaded Ukraine to prevent it from joining NATO and the European Union[xxxviii]. Countries around the world have sanctioned Russia for the invasion of Ukraine[xxxix].   The most impactful and serious action was to cut off many Russian banks and entities from the SWIFT International Payment System. European countries have frozen bank accounts and seized assets. Many countries have banned exports of military related goods to Russia. Europe is facing a shortage of oil and natural gas due to the sanctions and is trying to procure energy from other locations[xl]. After many years of globalization, we expect that we will see more regionalization and localization of supply chains.    

As a result, Russia and its citizens are being increasingly isolated and shut out from the rest of the world .Beyond the investment and economic conditions, there is also a massive humanitarian crisis with millions of refugees who have fled Ukraine[xlii]. The war has not gone as planned or as quickly as Russia had initially expected.

China

China’s stock market was one of the worst performers globally during the first quarter[xliii].   There is concern around slowing GDP growth as a result of the zero COVID policy and renewed lockdowns. Both of which could affect global supply chains[xliv].   There is also concern around the highly leveraged property sector, as many big property developers are restructuring their debt[xlv].  Chinese imports of oil and other natural resources from Russia have been slowed or delayed due to the Russia-Ukraine war[xlvi].   The Chinese government has been increasing monetary and fiscal stimulus to help drive the economy towards their 5.5% 2022 GDP growth goal[xlvii].  Many economists believe that the number is too ambitious and are projecting closer to 5% growth[xlviii]. Achieving stated growth goals to maintain stability is of increased importance in a year when President Xi is up for reelection.

Europe

The European markets also declined for the quarter[xlix].  Europe is facing a potential slow down due to higher-than-expected inflation, pressuring energy and food prices as a result of the Russia-Ukraine war[l]. 40% of Russia’s natural gas is exported to the European Union, so the sanctions are having a significant impact on the availability and prices of energy[li].  Inflation for March was 7.5% annualized, up from 5.9% in February[lii].   The European Central Bank (ECB) is planning to start raising interest rates this year and pare back its bond buying program to help fight inflation.[liii]

Summary

We believe that the outlook for the markets this year is okay, given the potential earnings growth and the stability of U.S. consumers and corporations.  In fact, the U.S. equity markets are viewed as safe, given the volatility in most asset classes.  As a result of persistent inflation and rising interest rates U.S. value-oriented stocks continue to look attractive. Like most, we have experienced the extreme cyclicality of oil and natural resources in the past and believe that prices will remain high.

Looking out to next year, given that Fed is behind in raising interest rates to combat inflation, we believe that we should be cautious. Maintaining diversified portfolios that could benefit during higher inflation and interest rate environment is prudent.  We continue to look to uncover what we feel are quality, well managed companies that may consistently generate and grow free-cash-flow.


[i] FactSet Data & Analytics, Charting

[ii] Ibid.

[iii] Ibid.

[iv] FactSet Data & Analytics, Charting

[v] Ibid.

[vi] https://www.yardeni.com/pub/fedbal.pdf

[vii]https://www.bls.gov/cpi/#:~:text=In%20February%2C%20the%20Consumer%20Price,over%20the%20year%20(NSA).

[viii] https://www.wsj.com/livecoverage/federal-reserve-meeting-inflation-march-2022#:~:text=The%20Fed%20raised%20interest%20rates,by%20the%20end%20of%202023.

[ix] FactSet Data & Analytics, Charting

[x] Ibid.

[xi] Ibid.

[xii] Ibid.

[xiii] https://www.wsj.com/articles/young-workers-rake-in-biggest-wage-gains-in-tight-labor-market-11646044201

[xiv] https://slate.com/business/2022/03/home-values-appreciated-income-housing-market.html

[xv] https://www.reuters.com/markets/stocks/live-markets-capex-dividends-or-ma-how-spend-36-trillion-2022-02-17/

[xvi] https://ihsmarkit.com/research-analysis/global-energy-sector-capex-strong-rebound.html

[xvii] https://www.forbes.com/sites/greatspeculations/2022/01/12/are-capex-cycle-stocks-poised-to-outperform-this-year/?sh=79a71a926443

[xviii] FactSet Data & Analytics, Estimates

[xix] https://www.conference-board.org/research/us-forecast

[xx] https://www.drillingcontractor.org/preemptive-under-investment-in-oil-gas-likely-to-lead-to-recurrent-economic-crises-in-coming-years-62126

[xxi] FactSet Data & Analytics, Charting

[xxii] https://www.cnbc.com/2022/03/16/oil-market-heads-for-biggest-supply-crisis-in-decades-with-russias-exports-set-to-fall-iea-says.html#:~:text=Russia%20is%20the%20third%2Dlargest,United%20States%20and%20Saudi%20Arabia.

[xxiii] https://www.cnbc.com/2022/03/16/oil-market-heads-for-biggest-supply-crisis-in-decades-with-russias-exports-set-to-fall-iea-says.html#:~:text=Russia%20is%20the%20third%2Dlargest,United%20States%20and%20Saudi%20Arabia.

[xxiv] Ibid.

[xxv] Ibid.

[xxvi] FactSet Data & Analytics, Charting

[xxvii] https://www.bloomberg.com/graphics/2022-russia-commodities-shortage/

[xxviii] FactSet Data & Analytics, Charting

[xxix]https://www.bls.gov/cpi/#:~:text=In%20February%2C%20the%20Consumer%20Price,over%20the%20year%20(NSA).

[xxx] FactSet Data & Analytics, Charting

[xxxi] Ibid.

[xxxii] https://www.marketwatch.com/story/u-s-government-bonds-just-suffered-their-worst-quarter-of-the-past-half-century-heres-why-some-investors-may-not-be-fazed-11648859211#:~:text=U.S.%20government%20bonds%20lost%205.6,U.S.%20Treasury%20Total%20Return%20Index.

[xxxiii] https://www.wsj.com/livecoverage/federal-reserve-meeting-inflation-march-2022#:~:text=The%20Fed%20raised%20interest%20rates,by%20the%20end%20of%202023.

[xxxiv] https://www.reuters.com/business/finance/bofa-citi-expect-multiple-50-bps-fed-hikes-this-year-inflation-bites-2022-03-25/

[xxxv] FactSet data & Analytics, Charting

[xxxvi] https://www.forbes.com/sites/simonmoore/2022/02/17/the-risk-to-the-stock-market-from-an-inverted-yield-curve/?sh=1368fdb74811

[xxxvii] https://www.cbs58.com/news/russias-economy-is-surprisingly-tiny-heres-why-it-matters-so-much-to-you

[xxxviii] https://www.wsj.com/articles/ukraine-russia-war-invasion-whats-happening-11646157211

[xxxix] Ibid.

[xl] https://www.cbs58.com/news/russias-economy-is-surprisingly-tiny-heres-why-it-matters-so-much-to-you

[xli] Ibid.

[xlii] https://www.wsj.com/articles/ukraine-russia-war-invasion-whats-happening-11646157211

[xliii] FactSet Data & Analytics, Charting

[xliv] https://www.wsj.com/articles/chinas-robust-growth-target-points-to-more-stimulus-ahead-11646546226

[xlv] Ibid

[xlvi] Ibid.

[xlvii] Ibid.

[xlviii] Ibid.

[xlix] FactSet Data & Analytics, Charting

[l] https://www.wsj.com/articles/eurozone-inflation-hits-new-record-raising-pressure-on-ecb-11648807405?mod=Searchresults_pos18&page=1

[li] Ibid.

[lii] Ibid.

[liii] Ibid.


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