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Quarterly Commentary – March 2022

The first quarter of 2022 brought a swift change relative to 2021 as the U.S. equity market went into a brisk decline that breached into correction territory with a 12% drop from the high and into early March. In the case of the Nasdaq Composite, it brushed bear market territory at negative 18% from its high. Then came a rebound that recovered a significant portion of those losses by the end of March. During this time, Energy and Commodity areas of the market have done very well. The following are performance numbers from various popular indexes. Please remember index numbers are not individually comparable to a properly diversified portfolio. Each portfolio may include an allocation to securities similar-to these indexes in varying amounts based on your personal risk tolerance and should only be compared in that context. Year to date for 2022, the S&P 500 was down 4.6%. The Dow Jones Industrial Average was down 4.1%. The Nasdaq Composite Index was down 8.9%. The Russell 2000 Index was down 7.5%. International equities as represented by the MSCI AC World Ex U.S. Index were down 6.0%. The MSCI Emerging Markets Index was down 7.6%. Fixed Income as represented by the Bloomberg Barclays Aggregate Bond Index ended down 6.0% for the year.

Volatility in the stock market is the one thing that is guaranteed in these unpredictable times. Resiliency is also a characteristic one could attribute to the stock market considering the state of the world at this juncture. A tragic war in Ukraine, a global energy shock, a Fed becoming more hawkish, inflation levels not seen in decades, supply chain issues and a tight labor market are all part of the current puzzle which has caused market participants to rapidly re-assess risks on a very frequent basis, driving much of this volatility.
The war in Ukraine has aggravated inflation pressures and constrained central banks around the world as they try to contain inflation by raising rates at the risk of limiting growth and employment. Central banks are choosing to prioritize inflation concerns over growth, thereby increasing the risks of a hard landing for the economy and adding to recession risk. This, at a time when the post Covid world had started stimulating pent up demand growth within the backdrop of supply chain challenges.

Dealing with energy security concerns as a new priority is also going to sustain higher energy costs in the near-term, fueling inflation. Other inflation drivers related to the war will come from the fact that Ukraine produces 25% of the world supply of wheat. Ukraine is also an important supplier of fertilizer and of auto parts to Europe. Although uncertainty on that front is very high, things could change very quickly. Nonetheless there is a shadow over the long term as the ramifications of what has happened will ripple through well into the future as the world potentially faces a return to cold wars and arm races with increased military spending. This will be a blow to globalization that will have the effect of reducing global growth in favor of supply chain, food and energy security. Given the complexity of global supply chains, minor shortages of raw materials and components can have an outsized effect on prices, at least temporarily. We expect that the U.S. will be one of the more resilient economies given its energy position and lower commodity consumption as a percentage of GDP. The U.S. equity market seems to also have absorbed a good part of the inflation expectation to the extent that it doesn’t remain embedded long term. Europe on the other hand faces a higher probability of a recession given the proximity to the conflict, its dependence on trade with Ukraine and Russia as well as the management of the refugee crisis.

U.S. companies have done a good job of maintaining earnings growth through managing their rising costs and challenges effectively. Growth also remains supported by the post-pandemic re-opening. With the related pressures mentioned, the forward margin guidance may not be as optimistic. With the recent stock market adjustment, it is possible that some of that may have been factored in.

It is important to note that fixed income investments such as government and corporate bonds which have been the staple of portfolio allocations to act as a cushion due to their low historical volatility relative to equities have presented a much less attractive risk/return profile considering rising rates and inflation expectations. Unless they were very short term, they have experienced a degree of loss not seen in a while. During years of declining interest rates with a very accommodative Fed policy they have been historically attractive. This dynamic has shifted for now.
If the Pandemic had not been enough of a challenge, we are now faced with a geopolitical backdrop that is one of the riskiest in decades. Nonetheless the world remains full of opportunities and the stock market is indicative of some recent optimism. The S&P 500 is up 8.8% since the low of March 8, led by many of the high-growth stocks that were significantly hit earlier in the year. Corporate earnings are expected to remain solid despite some profit margin erosion due to higher input costs.

Recent days have seen an appetite for more risk. The belief is that the U.S. economy is strong enough to handle what is coming our way. It is also possible that investors are buying equities as a hedge against inflation. That would indicate that investors are putting confidence in the ability of companies to figure out how to continue to make money, particularly in the absence of alternative investments that can provide returns in excess of the expected inflation. Keep in mind that simply keeping money in cash over the next year when inflation is expected to be elevated, possibly to the tune of 5% or more, will bring significant purchasing power erosion equivalent to getting a corresponding negative return on the cash. Another positive for equities will be about increases in productivity as companies continue to pursue growth and adopt labor saving technologies. Improvements in operating efficiencies in some cases will help offset some of these negative pressures.

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