Despite equity markets having a positive month across the board, all of the major indices ended the 1st quarter of 2022 in negative territory. Leading March’s gains was the Russell 1000 Growth, which added 3.84% (-9.22% YTD). Following closely behind were the S&P 500 (-4.95% YTD) & the NASDAQ (-9.10% YTD), which gained 3.58% & 3.41%, respectively during the month of March. Finally, for the first time this year, the value-oriented indices lagged the growth-tilted indices as the Russell 1000 Value (-1.25% YTD) & the Dow Jones Industrial Average (-4.57% YTD) posted modest gains of 2.63% & 2.32%, respectively.
March Stonemark Market Commentary
From a sector perspective, Utilities (+10.08% for the month of March), Energy (+8.78% for the month of March) & Real Estate (+7.28% for the month of March) led the way while the Financials sector (-0.35% for the month of March) was the only S&P 500 sector to end the month in negative territory. The Energy sector continues to be boosted by the ongoing Russia-Ukraine conflict & surging oil prices & the Real Estate sector is benefitting from a dramatic imbalance between high demand for homes & very little supply across the country. Looking at the Financials sector, which typically fares well during times of rising interest rates, the current interest rate environment (we will discuss this more in depth later in this commentary) does not bode well for the Financials Sector.
1st Quarter Earnings Preview
With March now in the rearview mirror, investors will be eagerly awaiting earnings results for the 1st quarter of 2022, which will begin with the big banks reporting their corporate earnings during the 2nd week of April. As we head into 1st quarter earnings results, Wall Street will be keeping a close eye on what corporate executives have to say with regards to how inflation, rising interest rates & the ongoing Russia-Ukraine conflict impacted their 1st quarter results & how future earnings results could be affected. Figure 1 below illustrates one theme that we saw quite a bit last year, which was companies exceeding their earnings estimates & forcing analysts to revise their future earnings estimates significantly to the upside.
However, Figure 2 below seems to indicate that analysts may have now overshot their earnings estimates for the 1st quarter of 2022. Of the 11 sectors in the S&P 500, analysts over at CFRA have revised 1st quarter earnings estimates to the downside for 6 of the 11 sectors. Additionally, earnings estimates for the S&P 500 as a whole for the 1st quarter have been revised to the downside by 0.55%, a stark contrast to the double-digit upward revisions that we saw in the first 3 quarters of last year.
However, despite the downward revisions for the 1st quarter of 2022, Figure 3 above shows that if earnings estimates are in-line with analysts’ estimates, that would still represent a 4.41% year-over-year earnings growth rate. Additionally, in CFRA’s most recent release of their earnings estimates, they are forecasting full-year earnings for the S&P 500 to come in at $225.89 – a 7.8% year-over-year growth rate compared to the $209.54 that was reported for FY 2021. With the S&P 500 ending the month of March at 4,530 & FY 2022 earnings estimates of $225.89, the S&P 500 finished the month trading at a 20.05x price-to-earnings multiple (“P/E multiple”), which is still quite a bit above the 5- & 10-year average 12-month forward P/E multiples of 18.6x & 16.8x, respectively. Furthermore, with the Fed raising interest rates for the first time since December 2018 & the markets now forecasting the effective Federal Funds rate (“Fed Funds rate”) to be at the 2.50-2.75% target range by the end of the year, which would imply raising rates by another 225 basis points (“bps”, 100bps equals 1%) it is difficult to justify a 20.05x P/E multiple.
The Fed Raises Rates & the Yield Curve Inverts
On March 16th, what Wall Street had long been expecting finally came to fruition when the Federal Open Markets Committee (“FOMC”) & Fed Chairman, Jay Powell announced that the Fed was raising the Fed Funds target range by 25bps to 0.25-0.50%. With the monthly Consumer Price Index (“CPI”) data coming in well above the Fed’s mandated 2% level for nearly a year, it was only a matter of time before the Fed would be forced to raise interest rates in an attempt to reign in the soaring inflation. As a reminder, the Fed has two key mandates when determining the appropriate monetary policy: price stability & maximum employment. With the unemployment rate falling to 3.8% in February (the final jobs report before the March FOMC meeting) & prices anything but stable based off of the soaring CPI, it is clear that monetary policy adjustments are necessary. Looking at the graphic below, February’s CPI print (remember, this data point is delayed by one month, so we won’t get March’s read until the middle of April) of 7.9% was the largest year-over-year change since January 1982 when we saw 8.4% year-over-year growth.
With no indication of inflation cooling off anytime soon, the Fed may be forced to be more aggressive with adjusting its monetary policy, which is something that Powell has hinted to in the past & was reiterated in the Fed Minutes from the March meeting. In the Fed Minutes, many participants indicated that they would be in favor of raising the target range for the Fed Funds rate by 50bps in one or more of the upcoming FOMC meetings, all of which are “live” meetings. In addition to raising the Fed Funds target range, the Fed has also said in past meetings that it will begin reducing the size of its balance sheet but has acknowledged that reducing its balance sheet is a relatively new monetary policy tool & that the setting of the Fed Funds target range will be its primary monetary policy tool. However, during his press conference following the conclusion of March’s FOMC meeting, Powell did have this to say:
With the size & speed of reducing the Fed’s balance sheet still somewhat up in the air, it is clear that adjusting the Fed Funds target range is still the Fed’s primary tool. Looking at the graphic below, market participants believe that the Fed will in fact raise the target range for the Fed Funds rate by 50bps. What is even more startling is just how dramatically market participants have shifted their views over the course of one month. The panel on the left is as of February 28th (a graphic we included in our February Monthly Commentary) & the panel on the right is as of March 31st. From a visual standpoint, these potential 50bps hikes occur where the next meeting’s highest probability (y-axis), skips a one of the target ranges (x-axis). For example, market participants are expecting a 50bps hike at the May meeting given the fact that the current Fed Funds rate target range is 0.25-0.50% & market participants are forecasting an 86.6% probability that the Fed Funds target range will be 0.75-1.00% following the May meeting. With that said, based off of the graphic above, the market is expecting 50bps rate hikes at the May, June & July meetings, followed by 25bps at the three remaining meetings in September, November & December for a total of 225bps left this year. Again, these probabilities need to be taken with a grain of salt as these probabilities are determined by future expectations of market participants, but it is the Fed who ultimately sets the Fed Funds targeted range.
Turning to the yield curve & referencing the graphic below, since the beginning of the year, we have seen the Treasury yield curve flatten at a pretty rapid pace, which finally culminated in some of the spreads between Treasury maturities slowly start to invert. In the days leading up to the Federal Open Markets Committee’s (“FOMC”) meeting, the spread between 7- & 10-year Treasury yields inverted for the first time since the beginning of the COVID-19 pandemic. Following the FOMC’s meeting in which they announced a 25bps interest rate hike, we saw the spread between 5- & 10-year Treasury yields also invert. Finally, on the last day of trading during the month of March, one of Wall Street’s favorite recession indicators, the spread between 2- & 10-year Treasury yields, briefly inverted.
So why is the flattening & inversion of the yield curve significant? Going back to 1975, there have been 6 recessions, which is defined by the National Bureau of Economic Research (“NBER”) as a “significant decline in economic activity spread across the economy, lasting more than two quarters that is normally visible in real GDP, real income, employment, industrial production & wholesale retail sales”. Looking at the graphic below, every recession that we have had since 1975 has been preceded by an inversion of the 2- & 10-year Treasury yields.
In order to understand the relationship between an inversion of the yield curve & subsequent economic recession, it is important to define a couple of terms. In economics, the term “yield curve” refers to the relationship between yields on short- & long-term fixed income securities that are issued by the U.S. Treasury. During “normal” times of economic activity, the yield curve is upward sloping, that is, yields on longer-dated fixed income securities are higher than the yields on shorter-dated fixed income securities. The economic rationale behind this relationship is that investors require more compensation for investing in longer-dated fixed income securities because of the inherent uncertainty & volatility between the time that the investor purchases the security & its maturity. Additionally, remember that the price & the yield on fixed income securities are inversely related, which means that when investors are selling fixed income securities, the price is going down & the yield is going up. The opposite is true when investors are buying fixed income securities; the price is going up as the yield is going down. So, when the yield curve inverts, it suggests that market sentiment for the mid- to long-term is souring. This is due to the fact that fixed income investments (especially U.S. Treasuries that are backed by the “full faith & credit” of the U.S. government) are typically thought of as the “safest” investment during times of economic uncertainty & market volatility. As a result, when economic growth begins to slow & concerns surrounding a looming recession grow, investors turn to buying long-dated fixed income securities to provide a buffer from falling equity markets.
With that “Economics 101” lesson in mind, the current yield curve composition is catching the attention of many Wall Street professionals. Prior to March’s yield curve inversion, the last time the spread between the 2- & 10-year Treasury yields inverted was in August 2019 & we entered a technical recession in February 2020. Now, we are all well too aware that the global economy was brought to a screeching halt by the COVID-19 pandemic & subsequent lockdowns, so, prior to the inversion in August 2019, the last time the 2- & 10-year Treasury yield spread was inverted was in June 2007 & the “Great Recession” officially began 6 months later in December 2007. As we always like to do when referencing history, we want to remind everyone that past performance does not guarantee future results. It is important to examine any & all contributing factors in order to make an educated guess as to what might happen in the coming months. With that being said, we believe that the Fed has put themselves in a very difficult position. It is clear that the Fed overshot to the downside, propping up the economy & the markets with its extremely accommodative monetary policy for more than two years. This monetary policy, coupled with ongoing supplychain issues, soaring commodity prices & geopolitical tensions in Eastern Europe has led to inflation levels not seen in decades. Now the question is, will the Fed overshoot on the upside now & send the U.S. economy into a recession? Raising interest rates will help bring inflation back to the Fed’s 2% target, however, the impact of higher interest rates will be felt by just about everyone. Higher interest rates are going to make mortgage & auto loans more expensive. Interest rates on credit cards will also likely go up. We will likely see unprofitable companies, who rely on borrowing at low interest rates just to remain operational, go out of business. There is no denying that inflation needs to be reined in, but it is going to come at a cost, one that could be significant.
As we enter the 2nd quarter of 2022, there are plenty of upcoming events that we will be closely monitoring. Arguably the most important of these will be the next FOMC meeting, but that isn’t until the middle of May. Between now & then, we will receive corporate earnings results for the majority of the S&P 500 companies. With the markets pricing in another 225bps of rate hikes before the end of the year, something that will lead to P/E multiple contraction, corporate earnings will have to beat Wall Street’s estimates in order to justify trading at these elevated levels. However, with the ongoing supplychain issues, sky-rocketing commodity prices & the looming possibility of a recession, companies certainly have the chips stacked against them. We would expect that companies who miss on earnings and/or provide lower forward-looking guidance to be met with negative price action, a theme that we saw during 4th quarter 2021 earnings season. On the other hand, companies who report stellar earnings, give upbeat guidance & have a strategy to weather a very uncertain macroeconomic landscape will most likely be rewarded. With so much uncertainty that could potentially wreak havoc on the equity markets, we will remain diligent in positioning our portfolios as we navigate what will certainly be a volatile rest of the year & beyond.
As always, please feel free to reach out with any questions or concerns.
Stay Safe & Stay Healthy!