1st Quarter Client Note

We finally turned the corner on Covid (hopefully) and now find our European allies facing the worst military crisis since World War II — and possibly on the precipice of a nuclear confrontation with the out-of-control Russian leader.

After being down by over 10% mid-quarter, the S & P 500 (total return) Index ended the quarter down 4.6 %; the worst quarter in two years. And there was plenty of additional red ink. International Developed Markets lost 4.81%, Emerging Markets fell 6.97% and Global Real Estate dropped by 3.81%. The only bright spot was Commodities – up 25%; with the price of oil hitting $130/barrel in March.

All the details can be found in the Quarterly Market Review form our friends at Dimensional Funds.

Value Trumps Growth

In nine of the last ten years, growth has outperformed value. But long-suffering value investors were “rewarded” in the first quarter. (As a reminder, value stocks are those that are relatively cheap based on one or more metrics, such as P/E or price/book value.) The Morningstar U.S. Large Value Index rose 1.6% in the first three months of 2022. Concededly, a small gain, but one that beat the Morningstar U.S. Growth Index by almost 15%. That represents the widest gap between value and growth stocks since the first quarter of 2009. Value stocks tend to outperform in inflationary and rising rate environments. We shall see if the trend continues.

Fixed Income – In A Rout

The Fed executed the first of what is expected to eventually be several short-term rate increases. And sales of much of the trillions of dollars of the Fed’s bond purchases made over the past several years are expected to begin soon; with the specter of rising longer-term rates. The yield on the 10-year Treasury note rose to 2.34% from 1.51%. Accordingly, the benchmark Blomberg US Aggregate Bond Index fell 5.93% — one of the worst quarterly losses on record; proving that while high quality bonds are generally safer than stocks over multiple market cycles, they can lose money in adverse conditions. This added insult to injury in balanced portfolios of stocks and bonds.

Nevertheless, it is still important to own bonds in a balanced portfolio. Higher bond yields, resulting from gradually rising rates, should compensate you over time for the immediate drops in price. As long as you don’t own long term bonds.

Emerging Markets – Managing the Risk, Seeking the Reward

Emerging markets have historically produced higher returns than developed markets. But at the cost of much higher risk/volatility. Typically, this risk comes from higher levels of corruption and lower levels of investor protection. Occasionally a country’s markets and/or economy will just blow up.  The economic fallout from Putin’s invasion of Ukraine caused Russian financial markets and products to implode. The ruble sank. The Russian stock market was closed for weeks. Many indexes and funds are now excluding Russian securities.

A small sleeve devoted to a broad, extremely diversified emerging markets fund, without too much concentration in any one country or sector can enhance portfolio returns for investors who have the fortitude to stick with the allocation.  Of course, it’s virtually impossible to completely avoid China, as that country dominates the category.  But a fund with country caps can mitigate this risk.

Keeping Your Cool in Turbulent Markets

Market drawdowns are normal. In 24 out the 94 years between 1928 and 2021 the market experienced top-to-bottom losses in excess of 20%. The key to managing these periods is knowing who you are as an investor and why you have chosen to undertake a certain amount of exposure to these risks.

Soft Landing? Maybe. Who knows?

The Fed has a difficult task. Raising rates to combat inflation while simultaneously not causing a recession. The US economy is booming. Unemployment is now at 3.6 %, just above the pre-pandemic 3.5%. Weekly unemployment claims are at their lowest levels since 1968. And the war in Ukraine wears on.

Emphasis on Diversification

Exogenous shocks are inevitable and present the greatest risk to investors. Things like pandemics, wars and in some sense, the financial termites that very few people saw in the runup to the Great recession of 2008. But it is impossible to forecast when and how severe they will be. If not for these risks and the willingness of investors to bear them, however, there would of course be no so-called “risk premium.”

It is cliché to say that the only thing certain is uncertainty. But we are in the midst of extraordinary geopolitical turmoil. The outcome of these world events and their policy response is utterly unknown.

As always, it’s best to be prepared for all eventualities. Things are going to cost more – at least in the short run. Markets are going to be volatile. But volatility isn’t the biggest threat. Attempting to avoid it is. Your portfolio should already be positioned to withstand it and include at least some asset class exposure to inflation sensitive investments as well as be prepared for future sell-offs if the war in Ukraine deteriorates.

Resilience and the ability to make course corrections will win the day. Continue to take care of yourself and do whatever you can to help our friends in Ukraine.

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