Market Update in Six Charts (OK, Five Charts and One Table)
We begin with inflation, which jumped to a 40-year high this year. Prices of commodities such as copper, aluminum, wheat, and oil already had moved substantially higher last year. Russia’s invasion of Ukraine in February exacerbated global supply chain issues and caused more upward price pressure in certain food and energy markets.
Prior to this year, the U.S. Federal Reserve (“the Fed”) characterized these inflationary pressures as “transitory”. Federal Reserve Board Chairman Jerome Powell has since revised that stance, citing inflation that is “much too high” and a rising risk of an extended period of high inflation. In March, the Fed raised what is known as the “fed funds rate”, which is the interest rate commercial banks charge when they lend their excess reserves to one another for extremely short periods—typically overnight. The Fed uses this tool to influence short-term interest rates throughout the economy. Higher short-term interest rates generally slow spending and help to cool inflation.
Short-Term Interest Rates
Even though the Fed sets very short-term interest rates, the markets determine most interest rates, and expectations of future Fed actions can have a substantial impact on financial markets. A case in point is the following chart of the yield on 2-Year U.S. Treasury securities.
This chart shows the interest rate (i.e., yield) an investor would expect to earn from lending money to the U.S. Treasury for two years. The Fed has raised the fed funds rate just 0.25 percent to-date, but the market for U.S. Treasury securities already has anticipated and priced in a much more substantial increase in short-term interest rates. This increase in short-term interest rates has a meaningful impact throughout the economy by raising the cost of borrowing for corporations and individuals.
Bonds and Changes in Interest Rates
When interest rates rise, bond prices tend to fall. The inverse also is true. On your Performance by Security report, you will see negative returns for the first quarter for your Short-Term Bonds and Global Bonds. The following point may seem counterintuitive at first, but investors with a long time horizon should prefer to experience near-term price declines on bonds in exchange for higher yields. Consider the chart below.
The inspiration for this chart is a short-term bond mutual fund that we recommend in many client circumstances. At the beginning of the year, the fund had a yield-to-maturity of 1.4 percent, which was the best expectation of future annualized return had interest rates remain unchanged. The orange line shows the growth of $1 invested over 10 years if interest rates had remained unchanged. Today, however, the yield-to-maturity for the fund is approximately 2.9 percent following an approximate -4.0 percent year-to-date decline in the fund’s net asset value. The blue line illustrates this initial price decline and subsequent return at the newly higher yield. It takes roughly three years for the higher yield to compensate for the initial price decline. The chart demonstrates that an investor with a 10-year time horizon is much better off with the higher yield, even after accounting for the price decline.
Growth Stocks vs. Value Stocks
Next up is the stock market. One of the dominant themes over the past several years has been the outperformance of “growth” stocks over “value” stocks. Growth stocks tend to have high sales and earnings growth expectations and often include high tech sectors in the economy. Value stocks have comparatively low growth expectations but also relatively low valuations.
Leadership shifted recently from growth stocks to value stocks, as shown by the cumulative returns in the table below.
Traditionally value-oriented sectors such as energy, utility companies, and financial services outperformed their high growth counterparts over the past few months as markets incorporated new expectations for higher inflation and higher interest rates. We’ll see in the months to come if this recent shift was the beginning of a larger trend.
Mortgage Rates and Food Prices
The overarching themes in the first quarter included the shifting landscape on interest rates and inflation and Russia’s invasion of Ukraine. Big changes in markets often introduce second-order implications that can create additional instability. We close with two possible examples. The first is related to the recent increase in interest rates.
This chart illustrates the average 30-year mortgage rate over the last decade. The 30-year mortgage rate in the U.S. has jumped from approximately three percent at the end of last year to roughly five percent in April. Significantly higher borrowing costs will have a major impact on the housing market with potential ripple effects through the economy, though this change has been so recent that the effects are not yet evident.
This final chart from the Financial Times shows the UN FAO Food Price Index, which tracks the international prices of a basket of food commodities.
According to the Food and Agriculture Organization (FAO) of the UN, nearly 50 countries depend on Russia and Ukraine for at least 30 percent of their wheat imports. Clearly, the war in Ukraine is worsening an already challenging global food situation. High food and fuel prices have led to protests and riots in Sri Lanka, Peru, and Pakistan, potentially foreshadowing a wave of protests similar to the Arab Spring unrest of 2011.
In summary, global markets are incorporating a new set of expectations that include higher prices for food and other commodities, as well as higher borrowing costs. These shifts will bring about additional changes in the global economy and in markets, the timing and nature of which are uncertain. We won’t be trying to predict what’s next. Our focus will remain on helping you implement a time-tested investment approach and continuing to refine your strategy around your life. As always, we look forward to our next conversation.