The first quarter tested the resilience of financial markets. Numerous economic and geopolitical issues are weighing on investors’ confidence about the future, while most traditional barometers are signaling the economy is on solid footing. Rising interest rates, supply shortages, geopolitical conflict and inflationary pressures have knocked down consumer confidence to historically low levels. Offsetting these concerns, economic growth is robust, the job market is strong, and the unemployment rate is historically low. These contradictory influences are increasing uncertainty in the financial markets and aggravating concerns about a potential recession or possibly even stagflation. We agree that there is a lot to be concerned about in the economy and in the world. While the short-term outlook appears quite murky, the long-term fundamentals of the US economy still look very bright. Positive demographics, industrial reshoring, technological innovation, and energy independence are just a few of those positive influences.
The US economy is bound to slow as rising consumer prices, higher interest rates and lower government transfer payments dampen consumer demand. It is not widely discussed, but a major cause of a downshift in economic growth will be the massive reduction in government stimulus. Government spending stimulated extra growth in the economy last year and has played a significant role in our current inflation situation – along with the supply constraints that economists thought would be mostly resolved by now. The Federal government, which accounted for 24% of GDP last year, is expected to spend $1 trillion less in 2022, a reduction of 14%. In addition, there is currently a record amount of tax revenue being paid into the U.S. Treasury. Through the combination of lower spending and higher tax receipts, the budget deficit is expected to drop from 18% of GDP to only 8%. We all agree that a lower budget deficit is a good thing in the long run, but it can create a fiscal drag in the short run that softens economic activity. The private sector continues to grow, and leading economic indicators are still flashing positive signals. We do not believe a traditional type of recession is in the cards any time soon, but slower economic growth is almost a given in 2022 as the economy transitions away from pandemic stimulus.
The U.S. total stock market declined 5.3% during the first quarter of 2022. Large cap stocks held up the best (-4.6%) whereas small cap stocks declined the most (-7.5%). International and emerging market stocks experienced similar declines of -5.4% and -6.9%, respectively. Underneath the surface, there was a clear divergence as value stocks outperformed growth stocks by 9%. The stock market also experienced its first correction in almost two years. At its lowest point in February, the S&P 500 had corrected 12% from its all-time high and small cap stocks were off 22%, although stock prices retraced some of the decline by quarter end. We need to keep in mind that stocks do not go straight up and do not have positive returns every year. Historically, market returns are negative in roughly one out of every four calendar years. Therefore, after stocks have almost doubled in value since 2018, it is reasonable to expect that stock prices could tread water for a few quarters while the economy transitions and the Federal Reserve begins a rate raising program. It is even possible that 2022 could be one of those negative return years. We do believe American business will continue to grow and prosper (not every year) and profits will be higher five and ten years from today. Recognizing the changes occurring around the world, we have been adjusting portfolios to areas we believe offer good value and are positioned to succeed over the next few years. For example, we have been deemphasizing foreign stocks and increasing weightings in small-mid cap US companies.
Fixed income investments are typically viewed to be the more conservative and less volatile part of investors’ portfolios. While this is the case most of the time, it did not hold true during the first quarter. Fixed income investments had one of their worst quarterly performances on record. The total bond market had a negative return of 6%, which was even greater than stocks. Long term Treasury bonds declined 12% in just three months. Thankfully, the Watchman fixed income allocation tilted towards short and intermediate maturities and thus experienced a smaller decline than the overall bond market. Why were returns so awful for bonds last quarter? Because interest rates rose very sharply over a short period of time. The 5-year Treasury yield increased from 1.37% to 2.42% in only 3 months. That means a person who purchased a 5-year Treasury on January 1st for $100 (par value), saw the price of that bond drop to $95 as of today – a 5% decline in value. The going rate on a 10-year Treasury rose from 1.63% to 2.32% – a market price decline of 7% on that bond. Interest rates have been rising because the economy has been strong, and inflation is running hot. However, we believe the most dominant reason for higher interest rates is from investors front running the Federal Reserve, which is expected to switch from being a buyer of Treasury bonds to a net seller beginning this month. Both stocks and bonds declining simultaneously effectively undercut the premise of diversification, which impacted investor psyche. However, bonds are not stocks and all bonds eventually mature. The outlook for bonds is much better today than 3 months ago and possibly any time during the last 3 years. The Federal Reserve’s policy shift to fight inflation at almost any cost should be encouraging news to bondholders. We also believe the bond market has already priced in essentially all the Fed’s current plans. While there certainly has been short term pain, we expect better results from fixed income investments over the next 12 months. There is evidence that the inflation rate is finally peaking and has a good chance of decelerating throughout the year. This would be welcome news for the bond market.
As a result of the increased volatility across markets this year, plus some regular housekeeping on our part, you may have noticed that trading activity has picked up across our portfolios. There are a few reasons for this. First, volatility gives us an opportunity to adjust the portfolio. Certain areas of the market have held up well, others have been beaten up badly. We made several moves based on this dynamic in the past several months. Second, to the extent there are unrealized losses in taxable accounts, we sometimes seek to capture those losses and trade into similar securities. A realized loss can be carried forward indefinitely and used to offset capital gains, thus reducing clients’ tax expenses. Lastly, we executed a few share class conversions. When certain fund share classes become available that have a lower internal expense, we will shift a position to the lower cost option. All this to say, increased activity isn’t a good or bad thing. It’s simply our investment team taking advantage of the opportunities available in the market.
With everything happening in the world, it can be a challenge to stay focused on the long term. That is why having a financial plan that balances all possible outcomes is key to achieving your goals. We can all be tempted to react to current events when uncertainties arise. Too often regret follows unthoughtful reactions. A better strategy is to remain rational, evaluate your financial situation, and create a response or a plan that is appropriate for you and your personal goals. We do not know how or when the current problems of the world will be resolved, but we do know they will be resolved, and different problems will arise in the future. The single most important thing to remember is that none of the current events are relevant to the investment policy of a long-term equity investor. Monies that will be needed over the next year or two should not be invested in equities. Monies that are not needed for a few years out will almost certainly earn a better return through ownership of stock in great companies than from almost any other investment.