After a historically calm and strong 2021, this year started off on shaky ground with US inflation surging to 40-year highs, economic growth and the trajectory for higher policy interest rates as central banks start rolling back policies implemented at the beginning of the pandemic remaining center stage. Russia’s invasion of Ukraine and Omicron intersecting with China’s zero-COVID policy were akin to adding kerosene to an already burning fire as this delayed supply chain normalization while impacting inflation even further and global economic growth expectations. Inflation expectations have kept the US Federal Reserve (Fed) center stage as they commenced their interest rate rising cycle in March. Navigating elevated inflation with slowing economic growth is a difficult balancing act for central banks. In line with our outlook from Q4, this also creates a more volatile and selective market.
Broad market volatility began to pick up during the first few days of 2022 as inflation readings hit multi-decade highs, confirming that price pressures were still accelerating. That prompted multiple Federal Reserve officials to signal that interest rates will rise faster than markets had previously thought, including a possible rate hike in March.
The prospect of sooner-than-expected interest rate hikes weighed on the sectors with the highest valuations, specifically growth-oriented technology stocks. The steep declines in the tech sector exacerbated market volatility in January. Additionally, while the fourth-quarter earnings season was solid, there were several large, widely held technology companies that posted disappointing results or forecasts, and that also contributed to general market volatility.
Finally, in late January at the Federal Open Market Committee meeting, Fed Chair Powell clearly signalled that the Fed would be raising rates at the next meeting (in March) confirming to investors that interest rates were going to rise much more quickly than had been assumed just a few months prior. The S&P 500 ended January with the worst monthly return since March 2020 (the onset of the pandemic).
Volatility remained elevated in early February with the market’s primary concern shifting from monetary policy to geopolitics as satellite imagery from October 2021 progressively showing greater movements of armour, missiles, heavy weaponry and Russian troops along the Ukrainian border, prompting warnings from the United States and other Western countries of an imminent invasion. The rising threat of a major military conflict in Europe for the first time in decades further weighed on stocks in early February. That additional uncertainty, combined with still-stubbornly high inflation readings and continued warnings from Fed officials about future interest rate increases kept global markets volatile throughout most of the month.
Then, on February 24th, Western warnings of a Russian invasion of Ukraine were fulfilled as Russia invaded in the early morning hours. The conflict sent essential commodity prices such as oil, wheat, corn, and natural gas surging as commodity producers and end users feared production disruptions and reduced supply. As one would expect, markets dropped in response to the invasion, and not just because of rising geopolitical concerns, but also as investors realized higher commodity prices will only add to existing inflation pressures, and in turn, possibly pressure corporate earnings and consumer spending. Geopolitical uncertainty combined with lingering inflation concerns and anxiety over the pace of Fed rate hikes weighed on stocks again in February, and the S&P 500 declined for a second straight month.
Global Markets remained volatile in early March, as hopes for a relatively quick ceasefire in Ukraine faded and commodity prices stayed elevated. Shortly after Russia’s invasion, the developed world united in a never-before-seen way against Russia, imposing crushing economic sanctions on the Russian economy. But while that demonstrated important unity against Russian aggression, it became clear that the sanctions would also have a negative impact on Western economies, especially in the EU, and that raised concerns about a global economic slowdown.
However, US stocks did mount a strong rebound from mid-March thanks to incrementally positive geopolitical and monetary policy news. First, the Ukrainian resistance stalled the Russian advance, and while the situation has devolved into an intense humanitarian crisis in Ukraine, fears of the conflict extending beyond Ukraine’s borders faded over the course of the month. Then, on March 16th, the Federal Reserve raised interest rates by 25 basis points, the first-rate hike in over three years. But the rate hike was no worse than markets feared, and that provided a spark for a “relief rally” in stocks that produced a solidly positive monthly return for the S&P 500 and carried the major US indices to multi-week highs by the end of the quarter.
Higher yields and reduced economic growth expectations are a consideration for central banks globally. With proximity to the Russia-Ukraine conflict and dependence on Russian energy, the European Central Bank (ECB) has certainly been navigating a tightrope between elevated inflation pressures and the potential for pricing pressure to erode economic growth.
At the March 10 meeting, the ECB prioritized fighting inflation, surprising markets by announcing plans to accelerate its exit from extraordinary stimulus even as the war in Ukraine deepened. Markets currently anticipate four ECB target rate increases in 2022, starting from July and increasing rates to 0%. We expect increasing divergence between the Fed’s and the ECB’s policy stance, which would put downward pressure on the Euro while being favorable to European versus U.S. stocks.
As inflation rises, real incomes and purchasing power may decline in the eurozone, potentially dampening economic growth. Despite the war reducing real economic growth projections while pushing up inflation, the ECB currently reflects a low risk of stagflation. Markets generally align with this view, with the German yield curve remaining upward sloping. The ECB’s worst-case scenario currently projects 2.3% real GDP growth this year while their base case scenario is 3.7% real GDP growth followed by 2.8% growth in 2023. Their worst-case scenario includes suppressed supply of Russia’s oil and gas and a worsening of the war, pushing inflation to 7.1% from a base case expectation of 5.1% in 2022. The ECB expects inflation to normalize around its target of 2% by end of 2023.
From the start of the year, the tone for most Asian equity markets was set by the release of minutes from the US Federal Reserve meeting, and the associated change in expectations for US interest rates. This helped to accelerate a change in market dynamics.
In Japan, this was especially evident in the outperformance of value-style stocks at the expense of growth. Much of this relative gain in value stocks was concentrated in financial-related sectors including banks and insurance.
Share prices in China were sharply lower in the quarter while shares in Hong Kong and Taiwan also fell. The number of Covid-19 cases in Hong Kong and China spiked to their highest level in more than two years during the quarter despite the Chinese government pursuing one of the world’s strictest virus elimination policies. The city of Shanghai, China’s financial capital with a population of 25 million people, went into a partial lockdown at the end of the quarter in a bid to curb a surge in Omicron Covid-19 cases, prompting fears that other parts of the country could also go into lockdown. Regulatory concerns relating to US-listed Chinese stocks also contributed to market volatility.
Emerging market (EM) equities were firmly down in Q1 as geopolitical tensions triggered a risk off sentiment around the world following Russia’s launch of a full-scale invasion of Ukraine. The US and its Western allies responded with a raft of sanctions. Commodity prices moved higher in response to the war, raising concerns over the impact on inflation, policy tightening and the outlook for growth.
Egypt, a major wheat importer, was the weakest market in the MSCI EM index, due in part to a 14% currency devaluation relative to the US dollar. Poland, Hungary and South Korea also underperformed.
Conversely, the Latin American markets all generated strong gains, led higher by Brazil. Other EM net commodity exporters posted sizeable gains, including Kuwait, Qatar, the UAE, Saudi Arabia and South Africa.
Bonds registered some of the worst performance in years during the first quarter with most major bond indices declining as investors exited fixed income holdings in the face of high inflation and as the Federal Reserve consistently signalled that it was going to raise interest rates faster than investors had previously expected and this pushed the US 10-year Treasury yield from 1.51% to 2.35%, with the 2-year yield rising from 0.73% to 2.33%.
In the corporate debt markets, investment-grade bonds saw materially negative returns and underperformed lower-quality but higher-yielding corporate debt, which also declined but more modestly so. This underperformance in investment-grade debt reflected the impact of rising Treasury yields, while the outperformance of high-yield corporate bonds served as a reminder of the still-positive outlook for the U.S. economy and corporate America, despite the macroeconomic headwinds of inflation, geopolitical unrest, and rising interest rates.
Commodities registered massively positive returns in the first quarter as reflected by the 29.04% return delivered by the S&P GSCI which is usually the benchmark for global commodity markets. Oil, wheat, natural gas, corn, and other essential commodities surged on a combination of actual production outages related to the Russia-Ukraine war (which reduced current supply) and buyers locking in supply for fear of any future production disruptions should the war continue for months or spread beyond Ukraine’s borders. Within industrial metals, the price of nickel was sharply higher in the quarter. Aluminium and zinc prices were also significantly ahead in the period. With precious metals, gold and silver achieved small gains over the quarter.
Looking Forward to Q2
As we start a new quarter, markets are facing the most uncertainty since the pandemic, as headwinds from inflation, less-accommodative monetary policy, and geopolitics remain in place.
Inflation still sits near a 40-year high as we start the second quarter and with major commodities such as oil, wheat, corn, and natural gas remaining at elevated levels as a consequence of the Russia-Ukraine war, it’s unlikely that key inflation indicators like the Consumer Price Index will meaningfully decline anytime soon. Until there is a definitive peak in inflation, the Federal Reserve is likely to continue to aggressively raise interest rates, and over time, higher rates will become a drag on economic growth.
The Federal Reserve, meanwhile, has consistently warned markets that aggressive interest rate hikes are coming in the months ahead, and this quarter we expect the Fed will reveal its balance sheet reduction plan, which will detail how the Fed plans to unload the assets it acquired via the Quantitative Easing program over the past two years. If the details of this balance sheet reduction plan are more aggressive than markets expect, or the Fed commits to more rate hikes than are currently forecasted by markets, that could weigh on stocks and bonds alike.
Furthermore, the Russia-Ukraine war continues to rage on, and the geopolitical implications have spread beyond the battlefield, as relations between Russia and the West have hit multi-decade lows. Meanwhile, crippling economic sanctions against Russia remain in place, while commodity prices are still very elevated, and the longer those factors persist, the greater the chance we see a material slowdown in the global economy.
But while clearly there are risks to global markets as we start the new quarter; Fundamentals, quality, and valuations remain key considerations to our portfolio positioning. The first half of the year will likely continue to be volatile as markets navigate commodity and economic growth shocks while simultaneously shifting to a higher bond yield environment. Our portfolio shall continue to balance inflation protection with the prospects of reduced economic growth, creating a framework that balances cyclical and defensive exposures while also having some balance between value and growth.
In summary, the first quarter of 2022 was the most volatile quarter for markets since the depths of the pandemic in 2020, as numerous threats to economic growth emerged. As we start the second quarter it is also important to note that the U.S. economy is very strong and unemployment remains historically low, and that reality is helping support asset markets. Additionally, interest rates are rising but remain far below levels where most economists forecast that they will begin to slow the economy. And consumer spending, which is one of the main engines of growth for the U.S. economy, is robust, and corporate and personal balance sheets are healthy. The January sell-off though is a reminder that volatility in markets is normal and that 2021 was the exception rather than the rule. Choppy markets are likely to persist until there is greater clarity on central banks’ ability to deliver a soft landing. As such, we shall continue to adjust & maintain a more robustly diversified approach that should be able to absorb these shocks and effectively navigate this investment environment until then.
This article was written by the Mansa-X Portfolio Management Team at Standard Investment Bank. For questions or clarifications, please type your comment below or drop us an email to email@example.com