This blog will serve as follow up to our previously released Q4 Investment Themes and is intended to provide an update on what we are seeing as well as our current outlook.
Here are the top three things we are covering in this week’s blog:
- The market fell in Q1 amongst slowing growth, rising inflation, and the breakout of war in Ukraine.
- Economic data has begun to weaken across the board with the emergence of Quad 4 slowing.
- With all of the unknowns ahead, we have shifted to an All-Weather approach that is designed to perform in all market environments.
After a strong finish to 2021, the market suffered steep losses in the first quarter of 2022. The slide began in the first week of the year on the back of a surge in interest rates and growing fears of economic slowing. With the Nasdaq already down over 10% from its peak, all eyes were focused on the January Fed meeting. Despite concerning commentary from Fed Chair Jerome Powell on inflation (A full recap of the Fed rate decision and the Powell remarks that knocked the stock market (cnbc.com)), the market rallied to close the month well off the previous lows.
February brought more turmoil for market participants. After a short relief rally, markets tanked on news that Russia had invaded Ukraine. Nonetheless, the immediate bearish reaction to the headlines fueled a “buy the dip” rally that brough the markets back up to above the previous lows.
Despite some optimism for a solution in Ukraine, the market rolled over once more in March as investors began to fear carnage in the U.S. economy. Peak selling came in mid-March when the S&P 500 finally capitulated and shot back to a more reasonable finish down -4.95%. With a stronger correlation to interest rates, the Nasdaq 100 was hit the hardest and finished -9.10%. The Dow Jones had a significantly smoother ride and closed a modest -2.17%.
Following a sharp rise in interest rates, the bond market had a historically poor month. Despite a small rally to end the quarter, long term bonds finished down over 10%.
Falling in line with the trend over the past year, Emerging Markets underperformed again in Q1. Despite a steep rally off the lows, concerns with the situation in Ukraine led to a close -7.32%. The World index outperformed EM but remained volatile with increasing global tensions, finishing the quarter down over 5.5%.
With the jump in inflation, Commodities rose by over 25% in the first quarter. Largely leading the charge was the spike Oil prices as consumers began to fear shortages from the Russia sanctions.
As quad 4 broke out in Q1, precious metals performed well. A combination of growing inflation concerns alongside worsening political tensions led Gold to rally to a one year high.
Similarly, Silver and Copper followed the trend and rose 7.63% and 6.52% respectively.
Macro Economic Process
Our process for model management is now expanded and based in a few key areas and comes from research from multiple research groups. One of the major shifts was incorporating more macro-economic data into our decision making. At a macro level, the economy is viewed through the lens of growth or decline and inflation or deflation. The research we receive from Hedgeye maps has where we are currently and where we are heading to probabilistically based on the data coming in. This is how we get the various quad outlooks that we refer to in our material.
The Quads – The quads are all about mapping the economic environment we are currently in, as well as using predictive data to identify the probable outcome for future quarters based on an analysis of Economic Growth, Inflation and Government Policy. The quads are broken down like this:
Quad 1 – Economic Growth Accelerating, Inflation Slowing
Quad 2 – Economic Growth Accelerating, Inflation Accelerating
Quad 3 – Economic Growth Slowing, Inflation Accelerating
Quad 4 – Economic Growth Slowing, Inflation Slowing
By understanding which Quad we are in, we can identify what asset classes have historically worked and which might struggle.
Coming off the turmoil in 2020, YoY GDP accelerated steeply throughout 2021. While growth rose slightly in Q4, our third-party research group significantly dropped (by over 0.5% per quarter) their GDP targets for future quarters. The largest contributing factor to this has been the worse than expected economic data released in Q1. Even though GDP is expected to remain above pre-pandemic levels, the negative YoY rate of change will be a significant hurdle for the market to overcome.
YoY CPI continued to surge higher in Q4 and is expected to rise further in the Q1 reading. While we do expect to see CPI come down in future quarters, the level of sustained inflation could create damaging effects on the economy for many years in the future.
The Russian invasion of Ukraine has only exacerbated oil and commodity inflation. According to Bloomberg, U.S. Households face a $5,200 inflation tax in 2022. In other words, depending on income bracket, the majority of lower to upper middle-class Americans will pay between $3,500 – $6,100 more in 2022 for the same consumption basket from prior to the record inflation spikes.
Pending home sales came down for the fourth consecutive month in February and now sit at a one year low. In correlation with the falling home sales, the 30yr mortgage rate spiked in Q1. The move represented the largest single quarter increase in rates in over 20 years. Because of the increase, home affordability dropped by tens of thousands in a very short period.
Amidst worsening global turmoil, historic inflation, and concerns of future Covid shutdowns, consumer sentiment has plummeted and is now sitting at the lowest level since the 2008 recession. With so many unknown variables, we could see sentiment remain poor for an extended period.
As a result of the spike in yields, the Fed is now needing to increase interest rates to fight inflation. At the same time, the economy has shown signs of slowing with several key indicators dropping. This combination of rising rates during an economic slowdown could spell trouble ahead. In addition, the market’s expected number of interest rate hikes continues to increase and is now anticipated to be over 8 for 2022.
Further amplifying worries is a historic quarter of YoY comparables ahead. Coming off the strong data from Q2 2021, the economy now faces a steep headwind in Q2 of 2022. Moreover, the stimulus checks given in the Spring of 2021 created a massive income surplus for lower income individuals. Stimulus, coupled with increased unemployment benefits, allowed for millions of dollars to flow freely into the economy and markets. One year later, those benefits have expired, and the weakening economy will face nearly incomparable data.
Financial markets continued pricing in a shift away from an economy with accelerating growth and inflation that we saw for much of last year. While we had been expecting this shift to occur, the outbreak of war Ukraine served as an immediate catalyst. In addition, commentary from Fed leaders throughout the quarter forced markets to price in an increasing quantity of rate hikes for 2022. As a result, the transition to the pricing in of a slowing economy occurred quicker than anticipated and caused a rapid correction in equities.
The market outlook for the second quarter of 2022 is now centered on decelerating growth and the likely beginning of decelerating inflation. With the Fed forced to tighten while the economy faces steep YoY comparisons, the setup for the market is challenging. Because of this, we enter Q2 with a defensive outlook, but will continue to monitor the signals and be prepared to adjust accordingly.
We hope you have enjoyed getting a deeper look into our investment research and look forward to providing this to you each quarter going forward. Thank you from the entire Konvergent Team!
 Slide 4: Major Indexes Drop
 Slide 5: Bonds Drop with Spike in Rates
 Slide 6: Global vs. Emerging Market Equities
 Slide 7: Commodities Spike
 Slide 8: Rally in Precious Metals
 Slide 11: Growth and Inflation
 U.S. Households Face $5,200 Inflation Tax This Year: Chart – Bloomberg
 Slide 12: Housing Market Troubles
 Slide 13: Consumer Confidence Collapsing
 Slide 14: Tightening Into a Slowdown
 Slide 15: Deep Quad 4 in Q2