Research Review: April 2022

Volatility spiked meaningfully in April and continued into early May as the U.S. government reported an unexpected contraction in economic activity in the first quarter, and the Federal Reserve (Fed) hiked the federal funds rate (FFR) by 50 basis points (bps), the first hike of this size since 2000. Performance across the major asset classes and sub-asset categories was overwhelmingly negative, particularly among rate-sensitive sectors, a dominant theme across the financial markets since mid-2021. Global equities fared the worst—particularly growth-oriented sectors—as the Russell 1000 Growth Index declined by 12.1%, the weakest monthly performance since October 2008. Small and micro-cap equities underperformed large cap, while both international developed and emerging market stocks relatively outperformed domestic, the magnitude of which placed these regional indices ahead of their domestic counterparts year-to-date through April. Fixed income markets continued to face significant rising rate pressure, with core bonds, as proxied by the Bloomberg U.S. Aggregate Bond Index, posting the weakest monthly return (-3.8%) since February 1980, when the index dropped 5.9%. High yield credit also suffered, matching the decline witnessed in core bonds. In real assets, rate-sensitive sectors such as real estate investment trusts (REITs) declined sharply, while commodities were among the few major sectors to see positive performance during the month.

Economic Update

Fed Hikes Policy Rate 50 bps Despite Contraction in U.S. Growth

Following a broadly risk-on bias in March, most major global risk sectors retreated meaningfully in April and early May. Several macro headwinds weighed on market sentiment, including a 50-basis-point hike to the policy rate by the Fed, COVID-19 lockdowns across China, the ongoing Russia-Ukraine war, and an unanticipated contraction in first-quarter U.S. growth.

For the first three months of the year, the Bureau of Economic Analysis (BEA) estimated that on an inflation-adjusted and annualized basis, the U.S. economy contracted 1.4%, according to the advance estimate of first-quarter growth released on April 28. The 1.4% decline juxtaposed to an optimistic sell-side median estimate of 1.0%, according to Bloomberg, and was the first negative quarterly GDP print since the spring of 2020.

Despite an increasingly challenging economic situation—which appears to have taken on a stagflationary tone in recent months—the Fed decided to increase the FFR by 50 bps at their early May meeting, placing the targeted upper bound at 1.00%. While largely anticipated by investors due to the ongoing inflationary issue and in light of recent bond market-implied policy path gauges, the 50 bps increase to the policy rate was the first such bps hike since 2000.

In addition to the 50 bps rate hike, the Fed provided forward guidance pointing to a reduction in the size of their nearly $9 trillion balance sheet by allowing $30 billion of Treasuries and $17.5 billion of mortgage-backed securities to begin rolling off in June, with expectations to increase the pace of this shrinkage three months later. Looming declines in the size of the Fed’s balance sheet paired with an expected steep policy rate path over the next two years represents one of the most critical headwinds facing risky asset prices in the coming quarters.

Immediately following the Fed’s announcement of the adjustments to their policy stance on May 5, most major risk assets moved sharply higher. Presumably, this was because investors breathed a momentary sigh of relief that the Fed did not hike rates by 75 bps—a potential move that Chairman Powell has suggested is off the table—or perhaps it was because the Fed failed to set forth even more hawkish forward guidance related to balance sheet reduction.

The following trading day, however, saw a pronounced move lower across risk assets as investors digested the evolving macro landscape, which appears fraught with a growing number of headwinds—most notably aggressive actions by global policymakers to slow the highest inflation rate in 40 years while grappling with an early-cycle growth slowdown amid continued elevated valuation levels across many key financial market sectors.

In summary, the month of April and early trading days of May presented global asset allocators with numerous volatility-inducing macro forces, which, when paired with an enduring inflationary impulse, helped send both risky assets and safe-haven sectors—such as core bonds—decidedly lower. In the months ahead, global policymakers will need to walk a delicate tightrope to slow the rapidly accelerating pace of inflation without sacrificing the ongoing economic expansion, which, while immature by historical comparison, is already exhibiting late-cycle characteristics, including a mostly flat Treasury yield curve, inflationary pressures, tightening monetary conditions, and a historically tight labor market.

Market Returns

Global Equity

• Equity markets continued to face significant selling pressure in April as global markets struggled to digest different factors that caused investor sentiment to weaken, such as the war in Ukraine, a zero-COVID policy in China leading to the lockdown of several important cities, relentless supply chain disruptions, and rising global interest rates paired with persistent inflation. U.S. equity markets continued this year’s sell-off as some market-leading, high-growth technology companies announced disappointing earnings expectations. The currency trade challenged international markets as rising U.S. interest rates have strengthened the dollar.

• The weakness in the U.S. equity market was widespread. Almost all sectors declined for the month, although the defensive consumer staples sector showed positive returns. Growth areas of the market have continued to drive the sell-off, while value areas of the market have better protected capital.

• Despite global selling pressures, UK equity returns were slightly positive in April in local currency but negative in U.S. dollars. Many large pharmaceutical and consumer staples companies in the UK benefitted from investor demand for defensive areas of the market. However, fears for domestic economic growth weighed on small and mid-cap UK companies. European returns were slightly negative in local currency as the war in Ukraine waged on. Sectors with higher supply chain risks, such as information technology, consumer discretionary, and industrials, underperformed relative to communication services and energy.

• The currency markets drove Japanese equity market performance. In April, the yen weakened considerably against the U.S. dollar, rising to 130 for the first time in 20 years. The Bank of Japan confirmed that there would be no change in policy; they will maintain a target rate of 25 bps for the 10-year bond yield. The increasing differential between the interest rates has weighed on Japan’s currency.

• Emerging market equity returns were also down for the month. China and Russia contributed significantly to poor equity performance in the region. China’s zero-COVID policy has dampened the economic outlook for the country, negatively impacting industrial metal performance. This caused industrial metals net exporter economies like Peru and Brazil to suffer for the month. By contrast, net energy exporters like Turkey, Saudi Arabia, and Kuwait benefited from strong demand and constrained supply.

Fixed Income

• Rates did not find relief in April, as all segments of the yield curve were subject to the relentless move higher. The 2-year U.S. Treasury yield rose 36 bps to 2.70% during the month, while the 10-year U.S. Treasury yield rose 54 bps to 2.89%. The 10-year/2-year Treasury spread closed in negative territory for the first time since August 2019 before rapidly steepening through the end of the month. By month-end, the widely followed metric rose 15 bps to 0.19%. Bond and stock prices moved in the same direction, so bonds did not offer protection from April’s general risk-off sentiment.

• While there was no Fed meeting in April, the market focused on the CPI release. March’s print, released in April, saw headline and core rise to 8.5% and 6.5% on a year-over-year basis. Early May’s release of April inflation showed inflationary persistence with an 8.3% headline measure. Fueled by the war in Ukraine, food and energy dominated the month-over-month increases. Energy, which comprises less than 10% of the index, increased a staggering 11% versus February and 32% since March 2021. Uncertainty surrounding the longevity of the war in Europe only served to stoke the inflationary embers.

• Corporate credit underperformed duration-matched Treasuries as spreads widened across the sector. During the month, the Bloomberg U.S. Credit Index (IG) and Corporate High Yield Index (HY) returned -5.2% and -3.6%, respectively. In a continuation of year-to-date trends, lower-quality credits outperformed higher quality. This counterintuitive dynamic is driven by lower durations and higher yields within lower-rated securities. New issue markets remained open but saw limited activity. Investment-grade concessions reached levels not witnessed since 2020 as market issuers enticed investors by offering 10-15 bps concessions to place new deals, significantly higher than the negative to low-single-digit levels present in 2021.

• Securitized sector performance mirrored that of corporates, with sectors underperforming duration-matched Treasuries. ABS, investment-grade CMBS, and MBS pass-throughs declined 0.8%, 2.3%, and 3.5%, respectively. The average 30-year fixed-rate mortgage increased 0.4% in April to 5.1%. This represents a year-to-date increase of over 60% through the end of the month. With the movement in borrowing costs, mortgage application activity collapsed 71% compared to April 2021, representing a four-year low. Infamous adjustable-rate mortgages (ARMs), popularized in the lead-up to the Great Financial Crisis, represented 17% of application activity on a dollar volume basis as borrowers sought to take advantage of the lower teaser fixed rate. As of April 28, a 5-year ARM offered a rate 1.3% lower than a comparable 30-year fixed-rate mortgage.

Real Assets

REAL ESTATE

• REITs declined in April on concerns related to the potential impact of higher interest rates on real estate values. Before their May meeting, the Fed signaled its intentions to raise interest rates by 50 bps as inflation readings continued to climb. Nearly all REIT sectors posted negative monthly returns, with regional malls, office, health care, and self-storage underperforming. At the same time, timber, lodging, and manufactured housing were the only sectors to post positive performance for the month. As of the end of April, the yield on REITs stood at 3.0%.

• Similar to the broader market, growth-oriented REITs—including the data center, cell tower, and industrial sectors—underperformed year-to-date through April, driven by valuations concerns, the potential impact of slower economic growth, and investors rotating into more value-oriented property types. Sectors exposed to consumer spending, including regional malls and retail, also underperformed year-to-date as consumer confidence weakened, most notably on discretionary items. Through April, however, hotel REITs outperformed and benefited partly from their potential to offer an inflation hedge due to their ability to reset rates daily.