March 2022 Market Commentary
As any investor knows, markets hate uncertainty, and in late February, in the hours and days following the outbreak of fighting in Ukraine, uncertainty reigned supreme. Initially, investors were concerned with how quickly Ukraine would fall, whether or not fighting would spread to NATO soil, and what impact retaliatory sanctions levied against Russia by the West might have on the global economy. Outgunned and outnumbered, initial expectations were that Ukraine would fall within a matter of days. However, thanks to unexpectedly strong Ukrainian resistance and support from the global community, Russia’s advances quickly stalled. Poor planning and inept execution by Russian forces also played a role. By late March, in the face of mounting losses of both men and equipment, Russia drastically altered its plans abandoning, at least for now, its efforts to capture Kyiv, to focus instead on eastern and southern Ukraine. Though it remains to be seen, the announcement may have effectively signaled the high-water mark in Russia’s efforts to seize control of the entire country. To be clear, significant uncertainties remain with respect to the fighting, but in the near-term it appears that the country will not quickly fall to Russian forces, nor will the fighting spread to surrounding NATO countries.
As the fighting in Ukraine shifted over the course of March from a lightning attack to a seemingly longer-term war of attrition, investors refocused their attention on inflation and the Fed’s plans to tame it. With inflation running at 40-year highs and being further exacerbated by the fighting in Ukraine and sanctions against Russia, the Fed raised rates by 0.25% at its March meeting. That marked the first rate increase since 2018 and the start of the first rate tightening cycle since 2015. When inflation first began to surge in 2021, it was largely contained to a few small parts of the economy such as used cars and hotels. A year later, prices are now rising uncomfortably fast across large swaths of the economy. Already facing criticism for being slow the react, the Fed is trying to prevent higher prices from becoming entrenched in the economy. Reflecting its more hawkish approach, at its March meeting the Fed revised its outlook for 2022 rates hikes from three, which it previously predicted in December, to seven. In addition, the Fed indicated that it was considering reducing its balance sheet starting as soon as May, whereas previously it was not expected to take such actions until later in the year. While some market participants welcomed the Fed’s newfound sense of urgency, others questioned whether it has swung from being too complacent to too aggressive. In an attempt to allay such concerns, Fed Chair Jay Powell noted that “the economy is very strong and well-positioned to withstand tighter monetary policy”.
Inflation notwithstanding, economic data released in March was relatively positive. February’s employment report showed nonfarm payrolls created 678K new jobs, the largest such number since July, and 10th consecutive month of 400K+ new jobs. Measures of economic activity within the manufacturing and services sector also showed continued expansion. Housing data was more mixed as starts rose to their fastest pace since 2006, reflecting continued strong demand, while sales of existing and new homes slowed, likely due to limited inventory and higher mortgage rates, which surpassed 4.5% for the first time since January 2019. Consumer data was a notable weak spot, with sentiment falling to a new decade low and spending slowing as well, albeit after a very strong January.
Stocks posted their best month of the year with the S&P 500, Dow Jones Industrial Average, and NASDAQ gaining 3.6%, 2.3%, and 3.4%, respectively. That was welcomed news after all three indices entered correction territory- down 10% or more from recent highs- at some point during the first quarter. Small cap performance was more modest with the Russell 2000 gaining 1.1%. International stocks continued to lag, with developed markets (MSCI EAFE) effectively flat for the month, while emerging markets (MSCI EM) fell 2.5%. Beyond the collapse in Russian stocks, the broader emerging market index was impacted by China, where the rapid spread of new coronavirus cases led to lockdowns of many areas, including large industrial centers. The lockdowns not only added to current supply chain woes, but also weighed on the country’s broader economic growth.
Commodities as measured by the Bloomberg Commodity index, gained 8.7%, led by a 16% gain in the energy subsector. Other commodities also saw significant gains. Both Russia and Ukraine are significant producers of a number of raw commodities including wheat, corn, oil, natural gas, coal, phosphate, ammonia, neon, and nickel. The importance of certain commodities such as oil and natural gas is obvious. The role of other commodities is less obvious, but perhaps no less important. Nickel is critical for the production of lithium-ion batteries used in most electric vehicles. Phosphate and ammonia are critical in the production of fertilizers used to grow crops. Neon is used in lasers required for the production of semiconductors. The combination of fighting and sanctions has severely limited the production and export of these commodities, putting further pressure on inflation, directly through increased commodity prices, and indirectly through further complications to global supply chains.
Fixed income, as measured by the Bloomberg US Aggregate Bond Index, suffered its worst month since 2003, and the eighth-worst on record due to inflationary pressures, the Russian-Ukraine conflict, and the combination thereof. Since taking a hawkish turn in late 2021, Fed commentary has become increasingly assertive. That was particularly true in the second half of March with the release of the Fed’s updated “Dot Plot”, and comments by various Fed members. In addition to the updated dot plot increasing 2022 rate hike expectations from three to seven, the newly revised forecast shows that the Fed is now prepared to raise rates above the anticipated terminal rate of 2.50%, to 2.75%, at least in the short-run, to quell inflation.
Just days after the Fed’s meeting, Chair Powell furthered the Fed’s hawkish lean, when he suggested the Fed is prepared to hike in 0.50% increments if deemed necessary. Given that inflation isn’t expected to slow by the next Fed meeting in May, it seems likely that the Fed would “deem it necessary” to follow through with the increased pace. Markets have already responded by pricing in 0.50% increases at both the May and June meetings. As of month-end, the market was currently anticipating a total of 250 basis points (2.5%) in hikes for 2022. As a result, Treasury yields pushed to highs not seen since mid-2019, and the curve flattened, inverting from the 3yr to the 10yr. Not surprisingly, 1Q22 was the third-worst quarter for fixed income since 1980, which was, not coincidentally, also the last period of excessive inflation.
Municipal bonds followed a similar trajectory as Treasuries, with yields on the AAA 10-year muni rising 63 basis points on the month, as compared to the 51 basis point move on the 10-year Treasury. The more aggressive move higher in municipal yields was attributable to significant outflows from municipal mutual funds, which sent supply up and added pricing pressure on top of that which was already created by a hawkish Fed.