Q1 2022 Commentary

Jordi Visser

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Late in November 2021, the Federal Reserve began removing the word “transitory” from its discussion of inflation. Not surprisingly, the market slowly priced in expectations of rate rises throughout 2022 in the following month. Adding fuel to the fire, inflation data in 1Q22 came in higher than market expectations. Next, in an unprecedented move, the White House stated that it was appropriate for the Fed to “recalibrate” its policy to fight inflation. Finally, the Fed used aggressive rhetoric about taming inflation and implemented its first rate hike since 2018.

These events created uncertainty as to where interest rates would be in the future. In fact, 2-year treasury rates increased 160 basis points in the first quarter, its largest quarterly rise since 1984 when Paul Volcker acted as the Chair of the Fed. The move in short-term rates was echoed by the worst quarterly performance for the Bloomberg US Aggregate Bond Index since Q1 1980. That was when Volcker raised the Fed Funds rate from 14% to 20% in his war against inflation. Furthermore, bond volatility, as measured by the MOVE Index, closed at its highest level since 2010. Lastly, with perhaps the biggest impact on investors and the consumer, 30-year fixed rate mortgages closed at the highest quarterly level since 2010.

If this abrupt move in interest rates was not enough, Russia shockingly invaded Ukraine and raised fears of World War III. These geopolitical events sent US gas prices at the pump up 93 cents within the quarter. This was the largest quarterly rise in almost 18 years. At the same time, the WTI Crude Oil Index briefly got above $130 during the quarter. The combination of these factors, with fears around rate hikes and a post-Covid fiscal drag, led many to question the possibility of stagflation and recession.

These fears seeped directly into the stock market and hedge funds. The CBOE Volatility Index (VIX) closed above 30 for 11 straight days. This took the 20-day average to the highest level since 2011 (outside of the early-Covid 2020 period). The S&P 500 Index SPX finished down -4.95%, while the tech-heavy NASDAQ 100 Stock Index (NDX) finished down -9.08%. Moreover, the relative performance of the NDX to the SPX had its worst quarter since the collapse of Lehman in Q3 2008. This cannot be overlooked because the technology sector has driven stock market performance and alpha generation since Lehman on the back of the rise of the iPhone. From Q3 2008 to the end of 2021, the SPX was up 309% before dividends with the technology sector (S&P 500 Info Tech Index) up +876% and the energy sector (S&P 500 Energy Index) down -14%. The result was over-owned technology names and vastly under-owned energy companies. Consequently, the ensuing mean reversion in Q1, with energy up +37.66% and technology down -8.55%, left many funds sorely mispositioned for the environment.

The negative performance in the equity and fixed income asset classes, combined with increased volatility across the board, and the dramatic underperformance of the technology sector, led to a negative quarter for the HFRX Equity Hedge Total Index and signaled difficulty for hedge funds. In fact, this is the first quarter since Lehman in 2008 that hedge funds, the S&P 500 Index and the broad-based benchmark Bloomberg US Government/Credit Bond Index all finished down in a single quarter.

As we head into Q2 2022, sentiment for all assets is low. We believe this creates an opportunity for surprises to the upside in the coming months. Economic indicators, such as the ISM and the job market, continue to show a healthy economic picture. Additionally, supply chain bottlenecks showed signs of easing in Q1. Lastly, crude oil, after the spike above $130 during the quarter mentioned above, settled down in March and finished Q1 2022 at $100.28. These signs of strength from the economy, alongside the long-awaited reopening from the pandemic, should help ease inflationary pressures now,  when investors are fearful of inflation and the potential for recession. Interestingly, periods of asset volatility like those witnessed in Q1 2022 have not historically resulted in recession. In fact, they provided significant opportunities for those in a position to provide liquidity. To reiterate, as market players continue to adjust their portfolios to accommodate a world of higher nominal GDP and contained but structurally higher inflation, we believe the current environment has strong investment opportunities.