Market Commentary - March 2022

Monthly Update

If we needed another reminder that the macro landscape has shifted to a different set of rules, the market gyrations and geopolitical tragedies in March definitely gave it to us. After a tough start to the year, which spilled into early March, stocks rebounded by the 2^nd week of March with the S&P 500 up 3.6% for the month, the NASDAQ up 3.4% and the small cap Russell 2000 index higher by a more modest 1%[1]. The Euro STOXX 600 was up .6%, but only after falling by 7.1% in January and February[2]. This was all happening as the war in Ukraine raged, commodity prices continued to rally, and worries about the global economy intensified with the US yield curve inverting.

Inflation continued to roar with the February CPI showing a 7.9% year over year increase, and even a 6.4% increase if we omit food and fuel[3]. We have to go back 40 years to find the last time that occurred. Caught completely flat footed after calling higher inflation ‘transitory’ for almost a year, the Federal Reserve finally raised interest rates at their March meeting by 25 basis points. They have also set up expectations for possible 50 basis point increases at upcoming meetings, along with the beginning of the balance sheet runoff process[4].

While the war in Ukraine has been horrific for the Ukrainian people, the impact on the rest of us has to do with another leg higher in commodity prices, particularly those of energy and food. With respect to energy specifically, Europeans are paying about 8x the price of natural gas that we in the US are paying on an equivalent BTU basis. Businesses in Europe that rely on natural gas as a feedstock are getting hurt, in addition to the average consumer.

With respect to the yield curve, as of this writing, the 2 yr yield is a few basis points above the 10 yr yield, and the 5 yr yield is 8 basis points higher than the 30 yr yield[5]. Those are two parts of the curve that I watch the most for my market signaling. Not every inversion is followed by a recession but every recession has been preceded by an inversion.

Along with the stock rebound in in March, off what was a very oversold situation in the immediate aftermath of the Russian invasion, corporate credit rallied too. The question now is whether the worst is over or not. I believe there is more wood to chop, as while the Treasury market has priced in many of the Fed’s expected rate hikes, I do not believe we have felt the impact of quantitative tightening and all the economic repercussions of inflation and higher rates.

I will end the beginning of this note with a positive and that is the world’s new approach to Covid. That is, live with it, deal with it. Yes, the new omicron variant is even more virulent as the initial one, but it is no more dangerous and it gets us further and further to broader immunity. Now all we need is China to shift its policy to being more tolerant, and the rest of the world can then benefit from Chinese consumer spending.

Inflation and the Global Economy 

I want to expand further on the negative impact of higher inflation when wage growth is not keeping up. I mentioned above that the February consumer price index rose 7.9% y/o/y. That compares to the March average hourly earnings figure that was just reported in the March jobs data that reflected a 5.6% year over year increase. Combining the two results in a decline in inflation adjusted wages. As consumers spend more on necessities they also are forced to spend less on discretionary items. This then, of course, negatively impacts overall economic activity.

If one lives in Europe, the higher price of energy is even more pronounced as not only are wages not keeping up, they are rising at a much lower pace when compared to the US. With respect to the rising cost of food, the CRB Food Stuff index was up 3% in March, after rising by 10% in February and 2.6% in January[6]. Again, more consumer income is going to be allocated to necessities.

As of the last read, the Atlanta Fed’s GDPNow survey estimates that Q1 GDP for the US will end up being 1.5% after a 6.9% increase in Q4, and we’ll get a good sense on how Q2 is shaping up when corporate American announces earnings in coming weeks.

China, the 2^nd biggest economy, is certainly also something to watch as their residential real estate sector, which makes up about 30% of GDP, is under stress. Their large developers took on too much debt and got way too aggressive with building in many of the 3^rd and 4^th tier cities.

Interest Rates and the Federal Reserve

Because the Fed so badly miscalculated inflation, they are now being forced to play a major game of catch up. After finally raising rates at their March meeting to a new range of .25-.50% they are still far behind inflation at 8%. Not only are they behind the curve, they are not even in the same stadium. Nevertheless, the market anticipates that the Fed funds rate will get to about 2.375-2.5% by year end.

The Fed is not the only one that is tightening monetary policy. In fact, many others have already begun. The European Central Bank, in particular, ended its Pandemic Emergency Purchase Program in March and could end its ongoing Asset Purchase Program in either Q2 or Q3 with rate hikes to follow. We might actually see their overnight deposit rate get back to zero this year. We will see…

What this all means is that the monetary tidal wave that boosted markets so much over the past two years in the face of covid is now going in the opposite direction. One has to be prepared for a more challenging economic and investing backdrop as a result unless one believes in free lunches.

Stocks and Corporate Credit

After a difficult beginning of 2022, both stocks and corporate credit bounced in March. Sentiment in early March had gotten too dour and that is usually a good backdrop for a reversal. To quantify that sentiment consider the CNN “Fear – Greed Index” which fell to 13 on the March 8^th market low. That reflected ‘Extreme Fear’ according to this survey. As of this writing, it is back to a more neutral level of 48 as it ranges between 0 and 100.

The next big test for markets will be earnings season that captures Q1 and we will get guidance for the rest of the second quarter, and maybe for the rest of the year. A key focus right now will be on profit margins and to what extent companies can offset their own rising cost pressures via labor and raw materials. Earnings estimates year to date have hung in well so far, and thus, the main reason for the year to date declines in stocks has been P/E multiple compression. Though I do expect that earnings revisions will be more to the downside than upside because of the economic challenges highlighted.

Conclusion

While the markets have experienced a nice rebound off the early March lows, I still expect a volatile and bumpy road for the foreseeable future. Higher inflation and higher interest rates coincident with tighter monetary policy is a macro landscape that is the exact opposite of what we have seen. While we, of course, hope that the economy can power through this, we cannot deny the heavy reliance it has had on very low rates and easy monetary policy. The positive though, as stated earlier, is that Covid as a force in our lives is pretty much over even though it is still infecting people. Moving on from the stop, start, stop impact of Covid is great to see.

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy and volatile time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.

Disclaimer