After a historically calm 2021, volatility returned in the first quarter of 2022, as inflation surged to 40-year highs, the Federal Reserve promised to raise interest rates faster than previously thought, and Russia surprised the world with a full-scale military invasion of Ukraine, marking the first major military conflict in Europe in decades. Those factors fueled a rise in volatility and pushed stocks lower in the first three months of the year.
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 the Federal Reserve signaled that it would be raising rates at the next meeting (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 February with the market’s primary concern shifting from monetary policy to geopolitics, as Russia amassed troops on 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 markets volatile throughout most of the month. On February 24th, 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.
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, stocks did mount a strong rebound in late March thanks to incrementally positive geopolitical and monetary policy news. First, the Ukrainian resistance stalled the Russian advance, and while the situation devolved into an intense humanitarian tragedy in Ukraine, fears of the conflict extending beyond Ukraine’s borders faded over the course of the month. On March 16th, the Federal Reserve raised interest rates by 25 basis points, the first-rate hike in over three years. 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 indices to multi-week highs by the end of the quarter.
In sum, 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, investors will need to see incrementally positive progress across geopolitics, monetary policy expectations, and the outlook for inflation if the late-March rally is to continue.
First Quarter Performance Review
All four major equity indices posted negative returns for the first quarter of 2022, although the S&P 500 and the Dow Industrials saw only mild losses compared to the Nasdaq and Russell 2000. Investors rotated out of growth-oriented, high-P/E technology stocks and into sectors that were more exposed to the traditional economy which, generally speaking, trade at a cheaper valuation relative to the tech sector. That rotation benefitted the Dow Jones Industrial Average primarily while the Nasdaq Composite badly lagged both the S&P 500 and the Dow.
By market capitalization, large-cap stocks outperformed small-cap stocks in the first quarter, and that was to be expected given the geopolitical uncertainty and rising interest rates. Small-cap stocks typically are more reliant on debt financing to sustain their businesses, and therefore, rising interest rates can be a headwind on small-cap stocks. Additionally, investors flocked to the relative safety of large caps amid the rise in volatility over the course of the quarter.
From an investment style standpoint, value massively outperformed growth in the first quarter as select value ETFs registered positive returns over the past three months. Elevated volatility, geopolitical uncertainty, and the prospect of quickly rising interest rates caused investors to flee richly valued, growth-oriented tech stocks and rotate to more fairly valued sectors of the market.
On a sector level, only two of the eleven sectors in the S&P 500 finished the first quarter with a positive return. Energy was the clear standout as the sector benefitted from the increase in geopolitical uncertainty and subsequent surge in oil and natural gas prices in response to the Russia-Ukraine war. Utilities, a traditionally defensive sector, logged a modestly positive return as investors rotated to defensive sectors in response to elevated market volatility and geopolitical uncertainty. Finally, financials relatively outperformed the S&P 500 and saw only a small loss as the sector has historically benefited from rising interest rates, although concerns about exposure to the Russian economy weighed on many financial stocks in February and early March.
Sector laggards included the communication services, tech, and consumer discretionary sectors as they saw material declines in the first quarter thanks primarily to the broad rotation away from the more highly valued corners of the market. Specifically, internet stocks weighed on the communications sector, while online retail stocks were a drag on the consumer discretionary sector. Away from tech and tech-related sectors, most other sectors in the S&P 500 saw modest declines that did not stray too far from the performance of the S&P 500.
Internationally, foreign markets declined in the first quarter. Geopolitical uncertainty hit foreign markets early in the quarter, erasing what was moderately positive performance until that point. Emerging markets slightly lagged foreign developed markets due to a stronger U.S. dollar and rising geopolitical risks, but the underperformance was modest.
In the fixed income markets, 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 signaled that it was going to raise interest rates faster than investors had previously expected.
Looking deeper into the bond markets, shorter-term Treasury Bills outperformed longer-duration Treasury Notes and Bonds as high inflation and the threat of numerous future Fed rate hikes weighed on fixed income products with longer durations.
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.
Second Quarter Market Outlook
Markets have exhibited very impressive resilience since the pandemic began and that remained the case throughout the fourth quarter and all of 2021, as the strength of the U.S. economy and corporate America helped produce another year of substantially positive returns in stocks. And that resilient nature will continue to support markets and the economy as we begin a new year.
Like all years, however, 2022 presents numerous potential challenges to economic growth, corporate earnings, and market returns, including a reduction in global stimulus, still stubbornly high inflation pressures, political uncertainty, and the ongoing pandemic.
Global central banks, led by the Federal Reserve, have already begun to reverse the historically accommodative policies that were enacted in response to the pandemic. The Fed specifically expects to end its QE program by mid-March and increase interest rates three times in 2022. That transition to more normal monetary policy will likely create headwinds on the economy and potentially corporate earnings. While historically U.S. stocks have performed well during the initial phases of a Fed rate hike campaign, we will closely monitor the impact of rate hikes on economic growth and the corporate earnings outlook as we move through 2022.
The reason the Fed is more aggressively removing accommodative policies is because inflation surged to 30-plus-year highs in 2021. Rising inflation did not have a negative impact on consumer spending or corporate earnings in 2021. But that risk remains as even optimists do not expect inflation to decline substantially in 2022. As we did in 2021, we will continue to monitor inflation closely to see if it becomes a negative influence on corporate margins and earnings, or consumer spending more broadly, because if that’s the case it will result in a rise in market volatility.
Politics will also be a source of potential volatility in the first quarter of 2022 and beyond. Democrats failed to pass the Build Back Better social spending bill in 2021, but the process is not over, and none of us should be surprised if that legislation passes in early 2022. From a market standpoint, investors will be most focused on any potential tax increases that might reduce corporate profits or consumer spending. Given the current version of the bill, market-negative tax increases look unlikely, but the legislative process is unpredictable, and we’ll continue to monitor the situation for any negative tax implications. Additionally, there will be midterm elections in November, and as is usually the case, we can expect the run-up towards the midterms to cause at least temporary market volatility.
Finally, COVID is not over. The Omicron variant, which is currently spreading across the globe, thankfully does not result in as many severe cases as previous COVID variants, but it’s still impacting society and businesses via worker shortages and more supply chain disruptions. And as we look ahead to 2022, we sadly must be prepared for more variants to impact the global economy, and we will continue to watch for any sustainably negative impacts from COVID on the economy or markets.
While markets face numerous risks as we start a new year, there remain multiple, powerful tailwinds on stocks and other risk assets. Corporate earnings remain incredibly strong and the performance of corporate America through the pandemic has been nothing short of amazing. Interest rates, while likely rising in 2022, remain low and are not yet close to levels that would historically be considered a headwind on economic activity. Personal savings remain high, unemployment remains low, and broadly speaking the U.S. economy is in strong shape.
So, while there are risks to the markets and the economy that could result in more historically typical market volatility in 2022, on balance the outlook remains decidedly positive.
More broadly, as we consider all that has occurred in 2021 and look forward to 2022, one of the biggest takeaways from another unpredictable year in the markets is that a well-planned, long-term-focused and diversified financial plan can withstand virtually any market surprise and a related bout of volatility, including multiple COVID waves, inflation reaching 30-year highs, and the Federal Reserve removing historic accommodation.
We understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this still-challenging investment environment. Successful investing is a marathon, not a sprint, and even intense volatility is unlikely to alter a diversified approach set up to meet your long-term investment goals.