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Navigating the Storm

Summary

Q1 growth slowed, the Fed is trying to fight inflation, but global economic growth remains positive.

These are the times that try investors’ souls. There’s certainly no lack of dark clouds on the horizon, and seemingly all around us at the moment. However, as difficult as it may be to look past the economic and geopolitical crises, that’s precisely what a long-term investment perspective requires.

 

Global growth slowed in Q1

Global economic growth slowed considerably in Q1 with the U.S. economy slipping into negative territory (-1.4%). Major supply shocks (COVID and the war in Europe), combined with years of easy monetary policy, have pushed inflation to its highest level since the early 1980s. Stagflation fears seem to dominate headlines everywhere.

To combat inflation, the U.S. Federal Reserve in March raised the Fed funds rate for the first time since 2018; interest rate markets now predict the Fed will raise the Fed funds rate to nearly 3% by year end (up from its current 0.38%). However, given the current state of the yield curve (it’s flat to slightly inverted), the Fed runs the very real risk of pushing the U.S. economy into recession in its mission to bring down inflation. Subsequently, there’s a very real prospect of a major Fed “policy error”, i.e., raising rates too far, too fast or not fast enough, far enough. It’s a difficult balancing act and the prospect of a “hard landing” (read: recession) seems more likely than not.

Further, this week’s FOMC meeting (the policy committee that sets interest rates) will provide insight into Fed’s new inflation-fighting bona fides; several weeks ago Fed Chairman Jerome Powell telegraphed a 50 basis point hike at their May meeting. Whether they do so, especially in light of Q1’s ugly -1.4% GDP growth rate, remains to be seen. That said, we should keep in mind that the Fed’s two mandates don’t say anything about maintaining positive economic growth—they focus explicitly on (1) price stability and (2) maximizing employment. The latter isn’t an issue currently; the former obviously is.

As a result of the challenging macroeconomic environment, most asset classes dipped further into correction territory last month. U.S. equity markets lead the way the way, with the Russell 3000 returning -9% for the month versus -5.5% for emerging markets and -6.5% for developed non-U.S. markets. Within all markets, value bested growth and multifactor strategies continue to outperform (relative to core) on a relative basis YTD through April 30.

In the fixed income arena, the Bloomberg US Aggregate and Global Aggregate bond indices returned -3.8% and -5.5%, respectively. Despite a difficult month for virtually all asset classes, it was nevertheless a month where diversification beyond just U.S. equities paid off on a significant (if relative) basis.

 

The Economy

  • Despite surging inflation, the war in Europe, and widespread COVID-related shutdowns in China, global economic growth remains positive. The IMF forecasts global GDP growth of 3.6% in 2022.  For globally diversified investors, this is welcome news.
  • Unemployment remains near 50-year lows, leading to relatively strong wage growth (currently, about 4%) and, subsequently, strong consumer spending growth. And let’s not forget that consumer spending makes up nearly 70% of all economic activity in the US.
  • Speaking of consumer spending, aggregate demand remains strong. Consumer spending increased year-over-year at a rate of nearly 3% in Q1—in stark contrast to the economy’s headline growth rate of -1.4% (which was negatively largely due to declining defense spending and surging imports due to a strong US dollar).

 

Markets

  • A combination of positive earnings growth and a broad decline in asset prices has brought down valuations. The S&P 500 now trades at 17.5x forward earnings, down from nearly 23x earnings in 2020, highlighting the value of continuing to invest through difficult market cycles (i.e., today’s investors are buying the same stocks for nearly 25% less than in 2020 and 2021).
  • Earnings growth continues to be strong. According to FactSet, with 55% of companies reporting, 80% have reported positive EPS surprises for Q1 2022. Consensus estimates are for 10.3% earnings growth for calendar year 2022 on topline revenue growth of 9.8%. These are good numbers that should help to bring down equity valuations further.
  • Relative returns for fixed income during the month, despite challenges associated with rising interest rates, still provided some semblance of diversification against equities (e.g., the Russell 3000 lost 9% in April versus -3.8% for the Barclays US Aggregate).

 

What’s next

All difficult markets have a beginning, a middle, and an end. This one too shall pass. But simply knowing the storm will end doesn’t necessarily make it any easier to weather. To do so, here are a few things investors would be wise to consider.

  • Maintain a long-term perspective. We’ve made it through bad markets before—the dot-coms, the global financial crisis, March 2020.  All ultimately came to an end with markets moving on to post new highs.
  • Focus on what you can control. Things like how much we save, how much we spend, our asset allocations, and the timing of major purchases and retirement are all things we typically have more direct control over. None of us can directly control markets, interest rates, or the war in Europe. We should resist making portfolio changes in response to things beyond our control and should instead focus on those that are.
  • It’s never too late to diversify or rebalance our portfolios, to reassess our risk tolerance, or to revisit our financial plans. All of these help us feel like we’re “doing something” at a time when doing nothing is probably the wisest course of action. However, we all know that sitting still is hard, especially while the storm rages. Subsequently, we encourage you to reach out to your advisor should you have questions, would like to revisit your financial planning and objectives, or reassess your risk tolerance.

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Footnotes:

Sources: JP Morgan Weekly Market Recap, May 2, 2022. JP Morgan Guide to the Markets, As of April 30, 2022.

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