The U.S. financial markets were quite weak in the first quarter, with broad-based stock and bond indexes down roughly 5% and 6% respectively during the period. April saw an acceleration of the equity market decline, with the S&P 500 index and NASDAQ composite index down 8.7% and 13.2% respectively for the month.
The damage done to fixed income investments thus far in 2022 has been severe, with the benchmark government/corporate bond index down 9.4% on the year. The yield on the index at the start of the year was slightly more than 2%, which has provided a scant cushion to the nearly 10% price decline of the index.
The sharp rise in interest rates also impacted the stock market, particularly those growth companies that hadn’t yet reached the stage of generating positive cash flows or net income. Raising the discount rate for those future earnings makes the earnings less valuable in present day terms, and this re-rating of growth stocks might continue if rates continue to rise from present levels. Value stocks in general have held up well thus far this year; energy stocks have been quite strong amidst the oil and gas price impact of Russia’s invasion of the Ukraine.
As the year has progressed, the Fed has been consistent on their need to raise short-term interest rates to slow the economy and reduce the historically high level of inflation. The interest rate futures markets are assigning a near certainty that the discount rate will be raised by 50 basis points this month, and the expectations are this rate will reach 2.5% by year-end.
We recognize that the investment background has changed dramatically, and not just as a result of war breaking out in Eastern Europe. After nearly forty years of declining interest rates, investors are now seeing the negative impact of rising rates on bond prices and long-duration equity values. A rapid increase in mortgage rates from 3% earlier this year to 5% at present has slowed down the refinancing markets substantially while housing prices remain stubbornly high. There are labor shortages broadly across U.S. industries, and the recent success of unionization efforts at Starbucks and Amazon signals a change in the relative relationship of labor versus capital. Still, the roughly 5% increase in annual wages has been more than offset by the near 8% increase in the Consumer Price Index.
The Federal Reserve board has a tricky challenge unwinding the unprecedented level of monetary stimulus administered to sustain our economy during the pandemic. The Fed must raise rates enough to slow down inflation, but not so much as to throw the U.S. economy into recession. While there have been periods of Fed-initiated rate increases over the past decade, these hikes were not in response to inflation but rather an effort to slow down economic growth. This time might truly be different, and it’s possible after 40 years of steadily declining interest rates that we are at the start of a new era of rising rates.
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