March 31, 2022

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Market Commentary 
Inversion; the action of putting something upside down or in the opposite position, order, or arrangement 

Yield curves are supposed to slope upward. For example, if you loaned your neighbor $1000 for a day, you’d probably ask for $1000 in return. But, if the loan were for a year, perhaps you’d ask for $1100. How much would you ask for if the loan was for 30-years? Even if your neighbor is a good friend, you’d want to be paid a premium for parting with your money for so long. Bond investors are no different. However, a funny thing sometimes happens, where bond investors charge a higher interest rate for a short-term loan than they do for a long-term loan. Why?  This “inverted yield curve” is a result of investors pricing in today’s inflation (and anticipated rate hikes), followed by rate cuts and a deflationary cycle in the future. An inverted yield curve, which occurred this past quarter, is also an event that has predicted future economic recessions with remarkable accuracy.  

However, an inverted yield curve does not mean stocks will go down. In fact, history suggests otherwise. The median gain for stocks one-year after an inversion? 9% higher.  After two-years, the median gain was 16% (source: Goldman Sachs Global Investment Research). Nobel laureate economist, Paul Samuelson, famously said, “The stock market has predicted 9 out the last 5 recessions.” It is possible that the negative stock market experienced in the first quarter was from investors pricing in a future recession predicted by the yield curve. However, stocks frequently have corrections, and perhaps the negative quarter was simply letting some air out of the balloon in a market that had gained a cumulative 100% in the preceding three years. 

Rising rates, skyrocketing oil prices, war in Ukraine, food inflation, housing affordability; stocks did not lack reasons to sell-off this past quarter.  However, despite reaching a correction level drop (meaning 10% down from the high marks) several times during the quarter, that same S&P index ended the quarter down about 4.5%.  While that is of course not ideal, given the remarkable run noted above and the volume of stumbling blocks to hurdle in this quarter, the rally back up to finish the quarter showed that investors retain the willingness to hold risk assets. Why did stocks rally back so strongly off those low points? We have referred to TINA in the past (There Is No Alternative), and perhaps that was in play in the rally. After all, bonds sold off at historic rates and mortgage rates rose to over 5%. With continued headwinds for bonds and real estate, investors may prefer stocks as a vehicle to keep up with inflation. And inflation remains the biggest concern for market participants. 

Along with the world, we have watched the atrocities in Ukraine with disdain for the actions of Vladimir Putin. But yet again, the person most impactful to US markets was Jerome Powell- along with the regional Fed governors. The Fed finally began their overdue course of interest rate rises with a modest 0.25% increase. Markets experienced some relief that the first increase was just a quarter point, and now the question is how many more rate rises will come- and when? In January, JP Morgan’s CEO Jamie Dimon shocked shareholders with a prediction that the Fed would have seven increases this year. Only three months later, the Futures markets are predicting as many as 10 to 12 more quarter-point increases this year.  We would anticipate the low-end of these predictions, as we believe this dovish Fed will hesitate to reduce liquidity too aggressively.  

The rapid adjustment of interest rate expectations has been destructive for bonds, and especially long-term bonds. Bonds have had an historically poor start to 2022, challenging conservative investors heavily allocated to this generally safer asset class. The 10-year Treasury yield recently exceeded 2.5%, after starting the year at 1.50%.  Just 15 months ago, 10-year yields were less than 1%. This rise in yields was a response to both the projected path of rate increases and the Fed winding down quantitative easing (buying bonds on the open market). We have generally positioned client portfolios with underweight positions to Treasuries and relatively low duration, and believe this has held up reasonably well during this year’s selling pressure. We are particularly positive on the middle of the yield curve, with our expectations that the market has been too enthusiastic about rate increases. 

Looking forward, we recognize that there is no shortage of reasons for investors to tread cautiously. However, we remain advocates of stocks because, even leading up to economic recessions, they have historically continued to have positive returns. While further significant government stimulus remains unlikely (but never impossible), there is still a sizable volume of cash available for households to utilize- and a key question will be how is that money actually put to work. The mid-term elections in November still project to see some transition in party seats, which as noted last quarter is quite typical for mid-terms. With that possible political stalemate in place, it will also be unlikely to see sizable changes in tax policy either. 

We have identified key data points in recent market commentaries. While these metrics may vary widely by quarter as we move still closer to the end of this Pandemic period, here is where they currently stand: 

• Valuations. Valuations remain elevated, but earnings growth along with some reduction in pricing has brought these levels down. The S&P 500 index ended the quarter at roughly 19.5 times earnings, lower than the level 12-months prior (source: JPMorgan). Continued earnings growth will remain key here to help sustain these valuations.  

• Economic growth. Following the 8% GDP figure from Q4, growth in Q1 of this new year is estimated closer to 1% (source: Atlanta Fed).  This projection is impacted by issues like inflation pressures and ongoing supply chain snags, but it would still reflect the economy digging out of the 2020 hole. Looking forward, as recession concerns may increase, this figure will be closely watched by the Fed as they guide rate policy. 

• Interest rates. The FOMC finally made their first rate change, increasing the lending rate by 0.25%. Futures markets speculate that we may see as many as 12 more 0.25% increases this year, but that seems overly aggressive even in the face of ongoing high inflation.  

• Currency. The dollar saw some rally during the quarter as investors sought a safe haven, largely due to the tensions brought on by Russian aggression. This trend may continue as uncertainty remains elevated. 

Asset Class Review 

The first quarter saw the S&P index finish negative, but as noted above stocks rallied well off the lows. Gains for the quarter were led by Energy, as oil saw a huge spike in price.  Other sectors with positive returns were Utilities and Financials. Growth-style stocks broadly sold down on concerns about overvaluations and higher costs of borrowing for future growth, with negative returns for Tech, Communications, and Discretionary sectors. 

The Barclays Aggregate Bond index was down over 5.5% for the quarter, as long duration Treasuries led bonds down with rate increases beginning. The High Yield index finished slightly better with a loss of 4.5% while investors continue to seek out yield. The broad bond world will eventually benefit from higher coupons on new bond issues. 

Alternatives allocations have the ability to provide value in this environment. Our preferred alts vehicle, the Goldman Sachs Absolute Return Tracker fund, finished the quarter ahead of both the broad stock (S&P 500 TR) and bond indexes (Barclay’s Aggregate). The ability to short some overvalued positions helped here, as did positioning to commodities- an investment class often associated with alternative investments. Commodities investments were led by an almost 40% increase in the price of Brent crude oil.  Agricultural commodities also saw a sharp increase in price, carried by concerns on items like wheat- of which Ukraine is a leading world producer.  Meanwhile, as inflation again reached new multi-decade highs, both Bitcoin and gold provided some gains, but not enough in our view to demonstrate correlations of “true” inflation hedges. 

Foreign developed stocks started the quarter well, then saw sharp selling as Russia’s disastrous invasion began. This asset class also rallied off the intra-quarter lows as further escalation of the war seemed less likely. Emerging Markets continued to experience issues with country-specific Covid lockdowns and China government restrictions toward social tech firms, but saw a huge rally up in China stocks as those actions began to alleviate. These markets continue to show much lower relative valuations and higher yields, but as we saw this quarter, they also face issues largely related to government activity. We continue to see upside potential in these classes,  and maintain recommended allocations here. 

Past performance is not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. Investing involves risk, including loss of principal. You cannot invest directly in an index. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Source: Morningstar 

The S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.  
The Barclay’s Aggregate Bond Index (Taxable Bond) is a broad base, market capitalization weighted bond market index  
representing intermediate term investment grade bonds traded in the United States. 

Headline Inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics. 
The Bloomberg Commodity Index (Commodities) is an index of the prices of items such as wheat, corn, soybeans, coffee, sugar, cocoa, hogs, cotton, cattle, oil, natural gas, aluminum, copper, lead, nickel, zinc, gold and silver. The index is calculated on an excess return basis and reflects commodity futures price movements. 

The MSCI EAFE Index (Foreign Developed Index) is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.  
The MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. 
Bitcoin Each crypto index is made up of a selection of cryptocurrencies, grouped together and weighted by market capitalization (market cap). The market cap of a cryptocurrency is calculated by multiplying the number of units of a specific coin by its current market value against the US dollar. 

All opinions and data included in this commentary are as of March 31, 2022 and are subject to change.  The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision.  The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.  Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.