For the first time in almost two years stock markets were decidedly negative during the first quarter of 2022.  In a complete reversal from 2021, the technology heavy NASDAQ index was the worst performer among major equity benchmarks with a three-month loss of 8.94%.  Small capitalized stocks (Russell 2000 Small Cap Index) were nearly as bad with a loss of 7.53% during the same period.  The S&P 500 and Dow Industrial Average defended much better with quarterly declines of 4.60% and 4.10% respectively.  The broad differentiator during the first quarter was value stocks outperforming growth stocks (Russell 3000 Value -.85% vs Russell 3000 Growth -9.25%).  Further examination refines the cause of the performance discrepancy as the level of exposure to the energy sector.  The S&P 500 Integrated Oil and Gas Index was up 39.71% from December 31, 2021, to March 31, 2022.  This should come as no surprise to drivers who have been paying over $5.00 per gallon of gas.

In other financial markets interest rates continued to climb, oil pumped higher, and gold moved solidly upward.  The elevation of all three of these economic indicators signal the presence of inflation.  On March 16th the Federal Open Market Committee increased the Fed Funds target to .25% (from 0%).  This was the first change in the Fed Funds target rate in two years.  It also simultaneously signaled the end of accommodative monetary policy and the beginning of anti-inflation policy.  The .25% increase in the Fed Funds rate caused a much more profound effect on intermediate term rates.  The 10-year U.S. Treasury began 2022 yielding 1.51% and ended the first quarter at 2.34% (Highest level since November 30, 2018).  The price of oil went parabolic as the Russian and Ukrainian conflict disrupted global energy markets.  The first three months of the year saw the price of West Texas Intermediate Cushing barrel of crude oil go from $76.08 to $100.28 (+32%).  Gold also reflected the heightened concern of inflation as the price of a troy ounce of gold gained 6.30% in Q1 2022.

Looking Forward

Currently, a debate exists among investors and economists on the financial condition (and direction) of the U.S. economy.  One side argues the United States is moving forward with increasing prices, growing corporate revenues, and higher wages (i.e. inflation).  The opposite side is constructing a case for an economic slowdown (i.e. recession).  This generates two important questions – 1.) How can these two diametrically opposite theories exist at the same time? 2.) which one is more likely to prevail? The answer to the first question is that inflation is occurring now (8.5% in March – Year over year) and there is a perception that an over-aggressive Federal Reserve will not only eliminate inflation but will also quickly push the economy into recession.  D’Arcy Capital’s answer to the second question is that inflation is far-and-way the most likely economic eventuality.  Investors should manage based on what is known (inflation), not based on what possibly could happen years into the future (economic slowdown).

Humans often rely on websites, news channels, or radio stations to understand what the weather will be like when they go outside.  Oftentimes, the best way to know what the weather is outside is to just go outside.  This example would serve well for individuals confused about the two possibilities of economic slowdown (recession) versus economic expansion (inflation).   Multi-media financial forecasts currently run the spectrum of economic conditions.  What is an investor to do with so much conflicting guidance? Go outside.  A quick field trip around the neighborhood will expose high fuel prices, rising home prices, nightly hotel rates that rival a monthly mortgage bill, busy eateries, sold out items, and help wanted signs on nearly every business door.  With this anecdotical backdrop, investors should set aside fears of a recession occurring anytime soon.  Additionally, all major financial indicators point to a robust economy that will easily incorporate the raising of interest rates by the Federal Reserve.  Once investors realize inflation exists, the solution is the easy part: invest in assets (like stocks) that can rise as inflation increases and limit excess cash balances as the real return on cash is currently negative.

The three economic concepts D’Arcy Capital is focused on for 2022 are: increasing interest rates, rising inflation, and FAANGM (six large cap growth technology companies) concentration risk.  D’Arcy Capital favors value over growth and small caps over large caps.  As inflation persists and interest rates move higher, it is important to have stocks that can adjust with price increases.  These include the energy, financial, and consumer discretionary sectors.  Sectors that struggle to pass on price increases such as utilities and consumer staples should be underweighted.  D’Arcy also favors inflation protected bonds (TIPS), short-duration bills and notes, and investment grade municipal bonds within the fixed income complex.

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