- War, rising inflation, growth concerns, and the resurgence of the Covid-19 pandemic hit the markets in Q1 2022, resulting in an unusual quarter where both equities and fixed income recorded negative returns. The commodities market rallied in response to Russia’s invasion of Ukraine, but remains highly volatile.
- The market is forward-looking by nature and a leading indicator. It has been pricing in a faster-than-expected Fed rate hike cycle, driven by continued inflation fears stoked by the war in Ukraine as well as supply chain constraints. China’s zero-Covid stance and the accompanying lockdowns exacerbate short-term concerns, and raises systemic concerns.
- All of these factors are incrementally taxing on future growth. Despite these macro concerns, such times of volatility are an opportunity to reassess individual risk appetites. It is even more important to focus on a strategic asset allocation that avoids blow-ups and focuses on the benefits of diversification, so as to be assured that the portfolios are appropriately positioned for the long term.
To experience an “unprecedented” event is to go through one that has never happened before. The term is used liberally, though where the markets are concerned, there are very few truly unprecedented events.
This, however, has been one of those rare times. It was an unprecedented market in the first quarter of 2022 — one of the worst starts to the year, and one of very few quarters when both equities and fixed income markets delivered negative returns. It was also the worst performance for fixed income markets in 30 years. If the markets end the year with the current performance, then another extremely rare outcome would have emerged — that of fixed income markets generating a second consecutive year of losses. We are less than a third through this year now, and there are a lot of things that can happen both positively or negatively from here on.
Investors have been riding on almost two years of benign and rising markets, following the March 2020 crash brought on by the global outbreak of Covid-19. That came to a halt at the start of 2022, with investors thrust into a perfect storm. Who could have predicted the February 24 invasion of Ukraine by Russia, which sent markets teetering perilously over the edge? The euphoria of low interest rates and government stimulus cheques that supported both consumers and businesses has reversed rapidly. Public market, especially growth stocks, have been pummelled.
The market has been pricing in a prognosis on Fed policy that has moved aggressively in favour of a speedier tightening — this is the predominant reason spooking markets. Inflation remains persistently high, and China’s tough Covid-related restrictions are hampering manufacturing in China, causing more concerns on rising prices. These shocks to the system are creating a negative spiral in both the equities and fixed income markets.
In particular, the fixed income sector — long regarded as a safe haven asset class — saw one of the worst falls in history. Overall, the equities and fixed income markets wrapped up March as one of the worst quarters in the past 25 years. The only certainty is more uncertainty and the resultant high volatility.
The markets are volatile because the outlook is murky and there are various permutations that have a broad range of outcomes. A good scenario could consist of i) an earlier end to the war ii) China pivoting its zero-Covid policy towards opening up and stimulating its economy iii) the market having already priced in all the Fed rate hikes and with inflation starting to ease with the high base effect, starts moving higher. A doomsday scenario would be pretty much the reverse of that with stagflation and worse: an unforeseen nuclear event.
We know that offering a prognosis on the direction of markets is a pointless and thankless task. For now, let us take stock of how the markets did in the first quarter before looking at the macro and market trends that will affect the future outlook.
Read more about Endowus Advised portfolios performance here
Global Equity Market Update
Amid heightened market turbulence, the global equity market saw a -4.9% fall in Q1 2022, with the MSCI ACWI Value Index outperforming the MSCI ACWI Growth Index by a significant margin. The Value Index was almost flat at -0.6% versus the -9.4% fall in Growth Index, a significant differential of 8.8% for one quarter. Historically, in rising rate environments, investors have shied away from growth stocks that trade at high multiples, and often without business profits to show.
Within sectors, energy stocks rose sharply together with the broad commodity market after the war broke out, reflecting concerns about the supply of energy and soft commodities, and specifically, out of Russia and the Ukraine. The next best performing sector was the defensive utilities sector. Interest-rate sensitive financials also performed better than other sectors as investors turned to stocks that may benefit from rising rates. These all represent the value segment of the markets.
The sanctions and resulting supply constraints and disruptions exacerbated concerns about inflation, causing a further drag on growth-oriented stocks. Investors also expressed caution on the European market, which has close economic ties to Ukraine and Russia. The increasing geopolitical risks dealt a stern blow to Asia and, in particular, the emerging markets (EM). Egypt and China were two of the worst performers. Egypt, as a major wheat importer, was hit by rising wheat prices and currency devaluation against the dollar. Meanwhile, as China continues its harsh battle against Covid-19 and places major cities under partial lockdown, growth concerns and regulatory risk drove its equity markets to new lows, impacting both the Asia and EM indices.
Global Fixed Income Market Update
The first quarter of 2022 was one of the worst periods of performance for the fixed income market. Inflation continued to remain stubbornly high and exacerbating the inflationary concerns has been the Russia-Ukraine war that has disrupted commodity and energy markets further. The breadth and persistence of price pressures prompted the Fed to adopt a more hawkish stance for monetary policy early in the first quarter. Sustained inflation expectations due to increasing commodity and supply chain disruptions have led central banks to tighten monetary policies across the globe.
In March, the Fed announced a 25 basis points rate increase, the first since December 2018. In May, it raised its benchmark interest rate by another 50 basis points, the largest since 2000. Given the forward guidance from the Fed, more rate hikes are projected. From the end of December 2021 to 31 March 2022, the US 10-year Treasury yield increased from 1.51% to 2.76% and shorter duration 2-year yields jumped from less than 1% to 2.58%, which was an unprecedented backup in yield and a rapid flattening of the yield curve. On May 2 (US time), the 10-year Treasury yields touched 3% — the first time since 2018.
This dramatic sell-off of bonds in the US — with bond yield movements inversely related to price movements — has resulted in the fixed income market recording the worst return in the past 40 years, even in the perceived safer markets such as the US Treasury market. Euro government bonds also sold off. The worst performing sub asset class was EM debt, which declined by 9.3% in Q1 alone.
Global Commodities Market Update
Most commodity prices soared in the first quarter on the back of rising energy prices and supply chain disruptions, exacerbated by the Russia-Ukraine war and the resulting economic sanctions against Russia. Both Russia and Ukraine are large exporters for commodities such as wheat, aluminium, nickel and palladium. As for energy, the EU gets nearly half of its natural gas imports and almost a quarter of its oil imports from Russia. It is not surprising then that the only sectors to post positive returns in Q1 in the MSCI All Country World Index were energy, materials and utilities.
Gold, considered a safe-haven asset and a hedge against inflation by most investors, gained about 8% in Q1. This was a reversal from the persistently negative return it generated throughout 2021 when it underperformed.
While these commodities have counter-inflation characteristics and are perceived as real assets, they are also a non-yielding asset class. Furthermore, the commodities market has historically been inferior to that of some other hard assets such as real estate, and growth asset classes such as equities over the long term. It remains a cyclical and volatile asset class. The chart below shows that the long-term returns of commodities has only just barely overtaken the fixed income asset class.
Global Macro & Market Outlook
The trifecta of war, rising inflation and the on-going pandemic has created a perfect storm for both equities and fixed income in the first quarter. We saw broad declines in both the equity and fixed income markets.The central banks continue to juggle between taming inflation and supporting the labour market and economic growth. The on-going pandemic has also continued to dampen a return to normal business, especially in China, with its zero-Covid approach. Several cities including Shanghai, its largest city, implemented large scale lockdowns from March. The negative impact on domestic demand and the manufacturing sector raises meaningful concerns about growth prospects with downgrade of growth forecasts, and as economies work through supply chain disruptions.
The Fed’s forward guidance indicates rate hikes at every Fed meeting for the rest of the year and market participants have priced in the expectation that the rate hike in May would hit 50 basis points — as it did — seeing that consumer inflation in the US is running at an annual pace of 8.5%. The market is expecting at least three consecutive hikes of 0.5% and reach at least 3% or higher by the year-end. Market yields have moved ahead of the Fed’s expectations. The flattening yield curve does not bode well for market expectations on growth.
The Fed is still hoping to achieve a “soft landing” for the economy, in avoiding a monetary overshooting that runs the risk of creating a recession. Inflation remains stubbornly high, and the Russia-Ukraine war wages on. Investors will look closely at how China works through its zero-Covid policy, and how it would impact global supply chains.
Following these developments, the IMF has revised down its global growth rates, warning that a meaningful slowdown could occur this year and continue into the next year. The current projection has the global economy expanding 3.6% in 2022, down from 6.1% last year. The new forecast is 0.8 % lower than its projection in January, and 1.3% lower than its October 2021 outlook.
However, rising interest rates in and of itself is not necessarily bad for equity markets. In fact, historically the table below shows that in the US market during the last six rate hike cycles by the Fed, the S&P 500 posted positive returns and the Bloomberg US Aggregate Index saw flat returns in only one of the rate hike cycles. In fact, the S&P 500 saw significant increases during the rate hikes.
Since this data is for the actual period from when rate hikes began and when they ended, a lot of this performance may have come after the markets had already reacted and priced in the rate hikes, having corrected ahead of the actual rate hike periods. This year, the Fed only executed on its first rate hike at the Fed meeting in March. The US equities market fell more than 12% from the beginning of the year, but rebounded after the rate hike. The fixed income market has also priced in almost all the rate hikes for the rest of the year.
Endowus believes that it is impossible to predict future market performance. More importantly, timing the market can be futile. As the numbers show, the market is often efficient at pricing in all known information and so individual investors find that when negative news actually comes out, the market rebounds when they expect it to fall, often because the negative news had already been priced in. This is why incremental change or news is important — or change at the margin. It is this delta or difference that often and largely drives markets directionally. But this is also why the markets are very fickle and it is much better to benefit from time in the market and having time on your side. Taking advantage of age-old wisdom in investing through diversified and low-cost portfolios and staying invested in markets through cycles allows you to have the highest chance of success, especially amid volatile markets.
Read more about Endowus Advised portfolios performance here
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