In the April issue of our monthly flagship publication, we feature:

  • On the Record by Chief Investment Officer Tony Roth explains how in a matter of weeks, it feels as if there have been decades worth of change, from economic, market, and geopolitical perspectives. The S&P 500 has responded with the first negative quarterly return in two years. At the same time, the index is down just 5.2% from its all-time high, and we cannot shake the feeling that a fire alarm is going off in the building and few are rushing for the exits. While markets don’t seem to adequately appreciate the downside risks, we do, and have taken a more cautious stance in portfolios.
  • Investment positioning and international equities overview.

“There are decades where nothing happens; and there are weeks where decades happen.” This quote—in addition to representing an exquisite irony—has proven as true in the first quarter of 2022 as it was when it was said by founder of the Russian Communist Party Vladimir Lenin over 100 years ago.

The last few months has seen an escalation of economic, market, and geopolitical risks across the globe. The S&P 500 has responded with the first negative quarterly return in two years. At the same time, the index is down just 5.2% from its all-time high, and we cannot shake the feeling that a fire alarm is going off in the building and few are rushing for the exits. That is not to say the building is burning, but the market today does not appear to adequately reflect downside risks. We believe a more cautious stance in portfolios is warranted, and we have taken down equity exposure in recent weeks.

Risks rising

Our latest Wilmington Wire blog post highlighted three interrelated risks to equity markets: 1) a commodity price spike associated with the war in Ukraine; 2) deteriorating sentiment among consumers and small businesses, in large part due to historic inflationary pressures; and 3) a hawkish Fed, which by the market’s expectations could hike the fed funds rate by 2.25% this year.

We need to add a fourth headwind to that list: the recent spike in COVID cases in China. The Chinese are working hard to stave off potentially high death counts that could ensue from the Omicron variant in light of the relatively poor vaccination profile of its overall population. To this end, the country has remained steadfastly committed to a “zero-tolerance” COVID policy and on March 27 announced a “rolling lockdown” of Shanghai, in addition to lockdowns in other less populous cities.

Shanghai’s population of 26 million people will be subjected to mass COVID tests, contact tracing, and isolation. Policymakers are doing their best to blunt the impact on economic growth and manufacturing, with shorter lockdown periods for key manufacturing firms like Apple supplier Foxconn. However, global supply chains remain stretched thin, and prolonged shutdowns of Chinese manufacturing plants or ports risk exacerbating shipping delays, input costs, and broader inflationary pressures.

Inflation is the single biggest risk to the economy and markets. It is contributing to the lowest level of consumer sentiment (as measured by the University of Michigan survey) since the 2011 debt ceiling crisis. Higher energy prices weigh excessively on lower-income households, with the share of total spending on energy for the lowest quintile by income twice that of the highest quintile. Businesses are feeling the pinch of higher costs as well, which is likely to erode record-high corporate profit margins, though by how much? The highest net percent of small businesses on record are indicating they are raising prices.1 At the same time, small business job openings and hiring plans are coming off the boil, and the historical relationship with wages would suggest more modest wage gains going forward. That is a key determination in our call for inflation to slow to 4.5% year over year (y/y) on the Consumer Price Index, or CPI (measures the average change in prices over time that consumers pay for a basket of goods and services).

Even if our projection for inflation pans out, the Federal Reserve is in the hot seat. If the CPI ends the year at 4.5% y/y, that will mean it spent the better part of 2022 above 6%. Absent a meaningful slowing in month-over-month inflation figures, the Fed will feel pressure to keep its foot on the brake until the policy rate is closer to neutral (the estimated rate at which Fed policy neither stimulates nor slows the economy). Expectations for Fed tightening are already being felt in the mortgage market, where the 30-year fixed rate is now 4.9% and the highest since April 2011. With housing, energy, and food eating up a larger share of spending, discretionary purchases on goods and services could slow.

Inflation is rampant outside of the U.S. as well. February inflation for the eurozone rose to a new record high of 5.9% y/y.2 Germany’s CPI surged to 7.3% y/y in March— the highest since the 1980s—and Spain’s inflation rate is nearly 10%.

The rapid reassessment of U.S. monetary policy has driven up short-term Treasury rates at a faster pace than longer rates, inverting the yield as measured by 2/10 spreads as we start the second quarter.3 An inversion of the yield curve has preceded every recession in the past 4.5 decades.

Please see important disclosures at the end of the article.

1 Source: National Federation of Independent Business, February 2022.

2 Sources: Bloomberg, Eurostat.

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