Q1 2022 marked the S&P 500’s first negative quarter since the COVID-19 driven sell-off of early 2020. During the first three months of the year, investors were hit with volatility from all angles, ranging from concerns over inflation and higher interest rates, to geopolitical uncertainty around the Russia/Ukraine conflict. This left nearly all equity asset classes in the red, with the S&P 500 declining by -4.60%, while non-U.S. developed stocks declined by -5.91%, and emerging markets equities lost -6.97%. Bond investors were not spared, as sharply higher interest rates led to losses of nearly -6% for the benchmark Bloomberg Aggregate Bond index, its worst 3-month return in more than 30 years. Commodities were the lone exception, gaining more than 25%, as the war in Ukraine drove prices meaningfully higher for everything from energy-related commodities to agricultural products.
Despite a 3.71% rebound in March, U.S. large-cap stocks ended the quarter markedly lower, declining by -4.60%. However, this does not paint the entire picture for U.S. investors, as performance was widely dispersed across styles. In fact, it was growth stocks that felt most of the pain, with large caps falling by -9.04% and small caps losing -12.63%. And diving even deeper, it was the highest-valuation, lowest quality segments of the market that were hit hardest, as they tend to see their shares most negatively impacted by higher interest rates. On the contrary, large value stocks held up relatively well, declining by less than -1% in Q1, buoyed by a more than 39% gain for the energy sector.
We saw a similar story overseas, where core developed, and emerging market indexes declined by -5.91% and -6.97%, respectively, while the value side of the market performed meaningfully better. In fact, investors actually saw gains of 0.33% from the MSCI EAFE Value Index, making it one of the very few equity asset classes to end Q1 in the black. However, the dollar did present a headwind to non-U.S. assets, rallying on higher domestic rates and the flight to safety trade. In total, U.S. investors saw a negative impact of -218 bps on their investments in non-U.S. developed equities and a -86 bps impact on their emerging markets investments.
U.S. investment-grade bonds struggled to start the year, declining by -5.93%, their steepest 3-month decline in more than 30 years. Investors saw little correlation benefit with the broadly declining equity markets, as the root causes of the sell-off, inflation and higher interest rates, negatively impacted both asset classes. From a rates standpoint, U.S. treasury yields increased meaningfully across the curve. However, the rise in rates was by no means parallel, with the 2-year yield rising by 160 bps compared to the start of the year, while the 10-year yield increased by just over 80 bps. This left the curve (10s minus 2s) within a stone’s throw of inversion at quarter-end, an event that many investors view as a recession indicator.
From a sector perspective, losses were widespread, leaving investors with few places to hide other than cash. High yield bonds held up marginally better than the broad investment-grade index (-4.84%), benefiting from relatively less interest rate risk and a cushion provided by their elevated income level. Additionally, spreads saw only marginal widening during the quarter, as bond investors have yet to price in any real risk of recession into corporate credit markets.
Commodities were an outlier during 2022’s first quarter, gaining 25.55%, while most other asset classes found themselves in negative territory. The primary drivers of such strong results were many of the same factors that produced headwinds for both equity and fixed income asset classes during the quarter, namely…higher than expected inflation and the fallout from the Russia/Ukraine conflict. Gains were seen across the entire commodities complex, ranging from energy-related commodities to agricultural products. The asset class also benefitted from a strong technical picture, with futures curves for many major energy-related products trading in a steep state of backwardation. This potentially increases total returns for the majority of investors who access broad-basket commodities either directly through the futures markets or via investment vehicles such as ETFs and mutual funds.
Closed End Funds
Closed end funds encountered a difficult environment in Q1, as two of the primary factors that impact premiums and discounts (i.e., interest rates and equity market volatility) worked against them. The end result was more than 200 bps of aggregate discount widening, leaving the universe much closer to the long-term universe average discount of roughly 450 bps than where it began the year. While this created performance headwinds for closed end fund investors during the quarter, it also created opportunities for tactical investors in the space. This was particularly true for municipal bond funds, which tend to carry a relatively higher degree of interest rate risk, and saw their discounts gap out by nearly 400 bps from year-end 2021 to March 31, 2022.
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