Markets remain under pressure so far in April as we approach corporate earnings season. Financial conditions are set to tighten with 2+% of interest rate hikes now expected from the Federal Reserve with a growing likelihood of a front-loaded 1% increase via 50 basis point hikes at its next two meetings. A more rapid runoff of the Fed’s balance sheet (quantitative tightening) is also expected. These technical changes will combine with real-world forces such as higher mortgage rates and gasoline prices to take more discretionary income away from consumers.
The potential silver lining is that inflation should be near its statistical peak. Prices might not fall, but they should stop rising so quickly. High and stable prices are not as friendly as low and stable prices, but regardless, stability would be a partial victory if the dreaded “wage-price spiral” and further surges in inflation expectations can be avoided.
Market Outlook and Q1 Summary
Overall Asset Allocation
At our Asset Allocation meeting in mid-March, the Committee decided to reduce equity risk. We moved to a general recommendation of market weight (neutral) to equities, retained a material underweight to bonds, and moved cash to further overweight while maintaining an allocation to diversified commodities. We also remain underweight international equities (in favor of overweighting the US) relative to benchmarks. Our turnover has been higher recently to adjust to the changing landscape, as we strive to balance tactical positioning with long-term strategic allocations to quality positions.
Equities are still more attractive than bonds on a relative basis, but equity valuations are not particularly attractive overall. However, the fundamentals of quality companies remain strong, and equities appear more reasonably valued after recent price declines.
Bonds are not yet an attractive counterweight to equity risk because both asset classes are vulnerable to rising rates. A cash cushion protects and preserves capital while we await better entry points for risk assets. Fortunately, the expected interest rate hikes should finally put some modest yield back into cash markets.
Stocks were down in Q1, but US stocks again outperformed international, with the S&P 500 down 4.6% and the MSCI All Country World ex-US down 6.0%; Europe declined 7.9% and China fell 14.2%. Within the US, growth stocks were particularly challenged with the Nasdaq Index down 8.9% and the Russell 3000 Growth Index down 9.3%.
Varied performance across industry sectors continued. Energy was the top performer at +39.0%. Utilities at +4.8% was the only other positive sector. The worst laggards were communication services (-11.9%) and technology (-8.4%). We have been opportunistically rotating sectors in 2021 and into 2022, but we also note that many technology and communications stocks have moved down by enough that they are now more reasonably valued and worth maintaining at these levels.
Profit margins are high and stable. However, they are about “as good as it gets” and are vulnerable as labor and input costs keep rising. These factors around pricing power will be closely watched in the coming earnings season.
source: Strategas, 4/11/2022
source: John Authers, Bloomberg, 4/6/2022
Overall, the bellwether Bloomberg Barclays Aggregate Bond Index was down 5.9% in Q1. US Treasury bonds, especially in middle and longer maturities, were down 7-11%. The two most common indexes followed by Cambridge Trust clients, the Intermediate Government/Credit Index and the 1-10 Year Municipal Blend Index were down 4.5% and 4.8%, respectively.
As the adage goes: “the Federal Reserve will likely keep hiking until something breaks”. There is the risk that the Fed will overcorrect and drive the economy into recession as an unfortunate consequence of its inflation fight. In any case, the market will eventually stop pricing in rate hikes and start to price in a recessionary environment and/or the eventual moderating of inflation—both outcomes would be more favorable to bonds. Our team is actively monitoring when it will be appropriate to increase our exposure to bonds. In the interim, our current holdings of high-quality government and corporate bonds remain creditworthy and serve as safe ballast for portfolios.
Other Asset Classes - Commodities
The Bloomberg broad commodities index was up 25.6% in Q1. Oil and agriculture were up sharply as the Ukraine invasion unfolded. Metals and virtually the entire commodities complex were up. Diversified commodity exposure remains appropriate to offset inflation risks and diversify beyond stocks and bonds.
There could come a time to rotate a portion of diversified commodities holdings(2) back into a dedicated gold position, given the sharp difference in relative performance on the broad commodity rally. However, we are comfortable with current positioning for now. Gold is often cited as a sufficient inflation hedge, but we feel that the broad commodities basket (which also includes some gold) is a more effective way to directly hedge the specific sources of the kind of inflation currently unfolding.
A recession might not be imminent, but we are likely moving into the later stages of the business/economic cycle. As conditions have changed, we have done some rotating within our holdings and expect to do more as opportunities arise. We reduced equities to neutral during Q1 in favor of holding a larger cash cushion during this economic and geopolitical volatility. As always, our strategic orientation toward high-quality stocks and bonds should provide stability through the economic cycle while also pursuing select tactical opportunities globally.
(1)Source: Strategas, 4/7/2022
(2)Clients in the SRI strategy do not hold commodities positions and we continue to review renewable energy opportunities for those portfolios.
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