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It was quite a first quarter:
The S&P 500 fell 4.9% in the first quarter, snapping a seven-quarter winning streak, while the Dow slid 4.6% and the Nasdaq 9.1%. The Russian invasion of Ukraine added volatility but oddly, the stock market is up since the start of the invasion.
U.S. bonds, a traditional haven during turbulent times, had their worst quarter in more than 40 years. Two-year Treasury yields spiked from 0.73% to 2.35% and now yield more than the 30-year treasury.
Commodity prices, in contrast, rose more in this quarter than in any quarter in more than 30 years. Inflation as measured by the Fed’s preferred gauge reached a new 40-year peak in February. The February rise was the fastest since 1982.
The average rate for a 30-year fixed-rate home loan jumped to 4.67%, the highest since December 2018. It stands to reduce affordability even further, but consumer interest hasn’t wavered so far. The number of applications submitted by hopeful home buyers has risen for three of the past four weeks, according to the Mortgage Bankers Association.
The Labor Department reported that employers added 431,000 jobs in March, marking the 11th straight month of job gains above 400,000. The unemployment rate fell to 3.6% last month from 3.8% a month earlier.
As we start the second quarter, growth is starting to decline from the torrid pace of 2021 as government and central bank subsidies fade. The Fed has finally decided to focus on inflation with its first interest rate increase and the futures markets are betting on many more increases this year. The U.S. economy is still projected to grow 3% in real terms this year. Earnings reporting season will commence next week with 55% of the S&P 500 companies reporting their first quarter earnings this month. The current consensus is for a 5.1% increase from last year. The more telling news will be managements’ forecasts for the year ahead and how much profit margins are expected to be squeezed by rising costs.
When short-term interest rates exceed longer-term rates, that is called a yield curve inversion. These inversions often precede an economic recession. The problem, of course, is that this ‘signal’ has not exactly been a perfect predictor of recessions in the past, and even when it has, the time frame could be from one year to three or more. Studies have indicated that the “best” yield curve signal comes from the relationship between the yield on 3-month T-bills and the 10-year Treasury Note. While the Treasury yield curve is quite flat from 2 years to 30 years, the short end of the curve is still positively sloped.
One of the best protections against inflation is investing in companies with growing earnings and dividend streams. In addition, stocks with lower valuations will compress less than those with higher valuations. We believe that balance sheet quality – low debt/equity ratios and high liquidity ratios – is even more important than normal. Companies with low fixed costs and high variable costs, that operate in industries with high barriers to entry or those with pricing flexibility will fare best in this environment. Bond durations should be kept short.