|Bloomberg US Agg Bond Index||-5.93%|
Last quarter I warned that 2022 was going to be a challenging environment for markets with fiscal and monetary policy creating headwinds. The market suddenly woke up to that reality this quarter. The S&P 500 finished the quarter down nearly 6% while global stock indices such as the FTSE All-World index were down more than 5%.
Bonds were no help, with US government bonds completing one of their worst quarters in terms of total return in history. According to Deutsche Ban’s Jim Reid, head of thematic Research, 10-year US Treasuries had their worst quarterly total return since the Great Depression. To make matters worse, inflation ran even hotter during the quarter and there are numerous indicators now warning that a recession may be on the horizon.
Inflation remained a major concern during Q1, with the consumer price index up 7.9% year over year at the end of February. That’s the highest level of CPI inflation in 40 years. What’s scary is that the CPI number doesn’t yet include the impact of Russia’s invasion of Ukraine. Russia is one of the world’s largest energy and commodity producers:
Ukraine is the 3rd largest exporter of corn and is also a major exporter of barley and rye. Combined, Russia and Ukraine make up ~30% of global wheat exports. Beyond the direct food exports out of Russia and Ukraine, the invasion is likely to boost food inflation and potential shortages through skyrocketing fertilizer prices. Russia is a major producer of the key inputs to fertilizer including ammonium nitrate, potash, and gas. The last time the world saw significant food inflation in 2010 it contributed to the Arab Spring and unrest around the world.
Commodities as a whole have soared:
Rising Interest Rates and Yield Curve Inversion
Over the past decade plus, the Fed attempted to use the wealth effect to spur economic growth. They did this by lowering interest rates and purchasing bonds in an attempt to spur risk assets to higher prices in hopes that would boost the economy. Now that inflation is running hot, the Fed is using the wealth effect in reverse, meaning they are willing to push down asset prices to put the brakes on inflation. Bill Dudley, Former President of the Federal Reserve Bank of New York said, “It’s hard to know how much the U.S. Federal Reserve will need to do to get inflation under control. But one thing is certain: To be effective, it’ll have to inflict more losses on stock and bond investors than it has so far… One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.”
The Fed increased their benchmark rate by 25 basis points to 0.25%-0.50% at their meeting in March. Many participants wanted an even higher 50 basis point hike. Banks like Citi and Bank of America are predicting the fed funds rate to go over 3% in early 2023. If anything, the Fed is behind the curve as they’ve kept interest rates at zero while still purchasing bonds through quantitative easing while inflation was at 7%+. Consumers are taking note, as the average 30 year mortgage rate just topped 5% according to mortgage news daily. If the Fed keeps increasing rates, borrowing rates for consumers and businesses will continue rising at a brisk rate.
The increase in short rates combined with market worries for the future of the economy recently led to an inverted yield curve, where short term interest rates were higher than long term rates:
Yield curve inversion has successfully predicted every recession in the US, although the indicator has been less meaningful globally (particularly when interest rates are zero bound as seen in Japan).
Other Recession Warnings
Macro Strategist Jim Bianco pointed out that every major surge in oil prices like the recent one has led to a recession:
Consumer confidence is also at levels generally only seen before recessions:
What does this mean for investors?
The stream of bearish news has seemed unending the past few months. Big picture I remain extremely concerned about the market given extremely high valuations in nearly all risk assets. Seeing various recession indicators flashing red also puts me on alert. However,it may still be relatively early in that process and markets often surprise us. According to LPL Chief Market Strategist Ryan Detrick, the last four times the 2/10 yield curve inverted the S&P 500 went up an average of 28.8% before peaking and it took 21 months on average for a recession to set in.
Here’s a look at short term market performance following yield curve inversions:
Post 1988 markets were strong in the year following yield curve inversions. The recent inversion is unique relative to past inversions given how early in the rate hiking cycle it occurred. The Fed has only increased rates once so far!
As always, when I think about positioning portfolios for the current environment I think overall market valuations and individual opportunities are the two most important factors. Here’s Meb Faber talking about just how unique the current extreme valuation of the US stock market is given this inflationary environment:
The market would have to fall by nearly half just to reach the highest valuation ever awarded to the US stock market when inflation was over 5% in the past. RBC research shows the average peak to trough decline in the market during recessions is 32%. However, bear markets in the US that have occurred with starting valuations at expensive levels have all been 50%+. While it wouldn’t surprise me to see the market reverse some of its early losses in the next couple quarters, I think that trying to capitalize on any short term gains is like picking up pennies in front of a steamroller.
Scott Caufield, CFA, CPA