Madison Client Communication | 1Q 2022

After three solid years in the equity markets, the first quarter of 2022 was a vastly different environment. It marked two years of pandemic complications including lost lives, business closures, lower labor force participation, supply chain disruptions, and higher commodity prices. The pandemic has also played a large role in the elevated inflation we are seeing today. Core inflation hit a 40-year domestic high in March, reaching an annualized rate of 6.5%. Although the Federal Reserve was already set to begin to raise rates, the high inflation rate has increased the urgency to raise interest rates to hopefully contain inflation. At its meeting in mid-March, the Fed raised interest rates by 0.25% and has reinforced its commitment to steadily raise rates throughout 2022 while simultaneously cutting its quantitative easing program. By late March, the yield curve inverted, often a signal that lower growth and potentially a recession are in the future. In addition, we witnessed the wanton destruction in Ukraine by the Russians in the first land war in Europe since WWII. This caused a spike in oil prices and pushed gasoline prices in the U.S. to new all-time highs.

The market volatility in the first quarter was often jarring and there were days and weeks where the S&P 500® Index dipped accordingly, by the end of March the S&P 500® was only down -4.6% for the quarter, a blip compared to the three strong years of returns we had seen in 2019 (31.5%), 2020 (18.4%) and 2021 (28.7%). Unemployment returned to pre-pandemic lows by quarter-end and corporate profits continued to be robust, despite the pressures of wage increases and surges in commodity prices. The Energy Sector was a beneficiary of $100-plus oil and led the market with a 39% return. The only other positive sector for the period was the defensive Utilities sector, with a 4.8% advance. Inflation concerns put a damper on consumer discretionary stocks, with the sector dropping -9.0% while related worries pushed technology stocks down -8.4%. As investors sought safety, value indices eked out positive returns while smaller stocks were seen as less capable of handling an inflationary and rising-rate environment and underperformed larger stocks. With interest rates moving higher in the first quarter, fixed income had one of its worst quarterly returns with the Bloomberg US Aggregate Bond Index down -5.85%. With the yield curve shift largely behind us, we expect fixed income returns to perform better from here.

As we look forward to the remainder of 2022, one wonders if investors have already witnessed the worst of what the year could bring or if further hurdles will appear. We have been assured by the Fed that the Federal Funds rate will continue to ramp upwards, indicating in March a much more aggressive path for monetary policy than just a quarter ago. Half-point rate hikes are no longer out of the question. Higher interest rates are generally perceived as a negative and are already pushing up mortgage rates and other borrowing costs, putting pressure on consumer spending. Yet despite the negative impact of higher rates, since 1994 the one-year return of the S&P 500 following an initial rate hike has been 7.3%. Of course, the dynamics are complicated, and a rate rise is often sparked by an overheated economy, mitigating the cause and effect of these results. Our current environment of high inflation requires a different calculus. But higher rates are not an automatic market negative.

As for the inverted yield curve, economist Paul Samuelson once quipped that an inversion "has predicted nine of the last five recessions." More practically, the timing between an inverted yield curve and a subsequent recession is so broad as to provide little useful intelligence, ranging from seven months to almost three years, during which the market can advance substantially.

In our view, the economic underpinnings of the U.S. seem solid and persistent. While the U.S. economy and consumers are impacted by rising oil prices, we are much more insulated than overseas economies. The end-of-quarter announcement of the release of a million barrels of oil a day from our strategic oil reserves may moderate gasoline prices in the U.S. Higher oil prices should encourage additional domestic production and exploration. Higher interest rates and an inverted yield curve signal slower growth ahead, but slow growth is not necessarily negative growth (recession). The American consumer balance sheet is strong and job demand continues to exceed supply by record margins. While the war in Ukraine is likely to drag on and continue to be a headwind for the global economy, the S&P 500 has advanced just over 7% since the invasion, and we don't expect that it will be a determinative factor in 2022 U.S. stock returns unless Russia becomes even more aggressive.