(Michael Corty, Morningstar) The S&P 500 generated a total return of negative 4.6% in the first quarter. Foreign stocks, as measured by the MSCI ACWI ex USA Index, declined 5.4%. Small- and mid-cap U.S. stocks traded lower, with the Morningstar US Small-Mid Cap Index down 5.4% for the quarter. Dividend stocks fared well this quarter, with the Dow Jones US Select Dividend Index up 5.3%.
War Adds to Unique Economic Environment
Before addressing the financial markets and investing, our thoughts are with the people affected by Russia’s invasion of Ukraine and its many consequences. The war is a heartbreaking development, and we hope for a long-term diplomatic resolution.
After Russia invaded Ukraine, the United States and European Union put severe sanctions in place against Russia. This helped push prices of several commodities that serve as key input costs for important products much higher. As we began 2022, among the key questions about the U.S. equity market were how long the recent spike in inflation would continue and when the U.S. Federal Reserve would begin to curb inflation via Fed funds rate increases and the downsizing of its balance sheet. The fed-funds rate is an overnight rate on lending between banks, and it influences borrowing costs throughout the economy.
During the March 16 Federal Reserve meeting, Chairman Jerome Powell indicated that curbing inflation is a top priority and suggested seven interest rate increases could occur in 2022. Five days later, Powell spoke at an economic policy conference and tried to alleviate fears that the Fed isn’t being aggressive enough by stating that the central bank was prepared to raise interest rates in half-percentage-point steps—high enough to deliberately slow the economy if it concluded such steps were warranted to bring down inflation. The Federal Reserve is attempting a balancing act of reining in inflation without stifling economic growth too much. Time will tell how this plays out.
In response, the yields on U.S Treasury bonds of short and long durations have increased, with the benchmark 10-year U.S. Treasury yield increasing from roughly 1.5% to 2.4% between the end of 2021 and March 31. This yield remains very low versus historical levels, but higher rates indicate that the era of ultra-low interest rates is changing, at least for now.
Impact on the Select Equity Portfolios
As portfolio managers we are accustomed to dealing with uncertainty. The current financial headlines include concerns about inflation, increases in interest rates, and supply chain challenges, with the war adding even more uncertainty to these already existing issues.
The Select Equity portfolio managers don’t attempt to predict the future level of inflation or interest rates. What we know is that economic conditions are subject to change and hard to predict. We don’t consider our portfolios to be heavily weighted for any one specific macroeconomic scenario, as our goal is to appropriately balance risk and reward by considering a wide range of outcomes.
We have a natural bias toward—and preference for—investing in high-quality businesses: those we believe have sustainable competitive advantages, strong balance sheets, and shareholder-friendly management teams. We believe companies with these characteristics tend to have pricing power, which can help offset increasing operating expenses during an inflationary period. We like high-quality businesses, but not at any price. We prefer to buy stocks when they trade at healthy discounts to our estimate of their intrinsic value.
Given the unusual economic circumstances, especially rising inflation, we expect upcoming corporate earnings results to have more variability and less predictability than usual. This could cause greater price fluctuation than we’re accustomed to for some portfolio holdings, even when there is minimal impact on the intrinsic value of the business. We continuously assess how our companies and management teams navigate the economic conditions. However, we’re focused on the earnings and cash flow that will be generated over the next five to 10 years, not the next quarter or two.
In some cases, it may take some time for companies to adjust to the current economic backdrop. When assessing our holdings and potential new companies for investment, our aim is to strike a balance between not overreacting to short-term events and incorporating new information about businesses that could change (both higher and lower) long-term cash flow generation.
At the conclusion of our previous Focus on Equities letter we suggested that investors prepare themselves for a more volatile set of returns, as the path forward could be bumpier than what occurred in 2021. We saw potential signs of this volatility in the first quarter. The S&P 500 index declined by nearly 13% through early March as the Russia-Ukraine war was in its initial stages. Then the market rallied in the final three weeks of the quarter to end down about 5%, serving as another reminder that short-term price movements can occur for any variety of reasons.
We recognize that investors can get distracted and feel more unsettled during periods of higher volatility. Your financial advisor can help you make sure your asset-allocation plan is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.
As always, we thank you for your business.
