Market Recap

A lot has happened since our year-end letter just three months ago. The biggest macro event is Russia’s brutal invasion of Ukraine. While the human impact has been devastating and tragic—and our hearts and support are with the Ukrainian people—our job here is to focus here on the economic and financial market impact of this event.

It was a rough first quarter across the board, with stocks, bonds, U.S., international and emerging markets all hurt by rising interest rates, inflation and the war in Ukraine. Global stocks (MSCI ACWI Index) fell 5.4% for the quarter. Among major global markets, the S&P 500 was a relative outperformer, dropping 4.6%, compared to a 5.9% loss for developed international markets (MSCI EAFE Index) and a drop of 7.0% for Emerging Market (EM) stocks. The relatively mild declines for the full quarter masked the intra-quarter volatility, where peak-to-trough declines were much larger.

Unusually, the damage was worse in the U.S. core bond market than the U.S. stock market. The benchmark Bloomberg U.S. Aggregate Bond Index (the “Agg”) fell 5.9% for the quarter. This was the second-worst quarter for the Agg since Q1 of 1980, when Paul Volcker’s Fed was in full-bore tightening mode. In the fixed-income markets outside of core bonds, high-yield (lower credit quality) bonds lost 4.5%, while floating-rate loans had just a 0.1% decline.

Portfolio Update

A period of rising inflation and rising interest rates creates challenges for both bonds and stocks, and in turn for a traditional balanced portfolio comprised only (or largely) of core bonds and stocks. Diversification into other asset classes, market segments and alternative strategies can be particularly valuable in such an environment.

In terms of our fixed-income allocation, our tactical positions in flexible, actively managed bond funds and floating-rate loan funds again added value relative to the core bond index from which the positions are funded, although they posted absolute losses. This was not surprising given the interest rate and credit market backdrop during the period, with Treasury yields sharply rising and corporate bond spreads widening.

On the downside, our tactical overweight to EM stocks detracted from relative performance. After a strong January, EM stocks gave up ground in the latter half of the quarter, trailing U.S. stocks and bonds. Our active EM fund managers, in aggregate, also trailed the EM index.

Uncertainty is High and Diversification Is Key 

The war in Ukraine has caused massive human suffering. From an economic and investment perspective the war is a “stagflationary” supply-shock: it fuels higher inflation via sharply rising commodity prices (especially oil) while also depressing growth via negative impacts on consumer spending. It is also triggering various government and central bank policy responses, which create additional risks and uncertainties for the economy and markets, given already-high inflation and decelerating growth coming into the year.

The COVID-19 pandemic is another wildcard but here the news has been getting better. Over time, the economic damage and disruption should continue to recede, which would support economic growth and mitigate some of the inflationary pressures coming from supply chain disruption and the subpar recovery in the U.S. labor force participation rate, which has contributed to higher U.S. wage inflation and increased the risk of a self-reinforcing wage-price spiral taking hold.

As we’ve often said about shocking events—in this case a global pandemic followed by war: no one knows how things will play out, and if they think they know, they’re fooling themselves. As Nobel Prize winner Daniel Kahneman put it: “The correct lesson to learn from surprises is that the world is surprising.” In short, we want to build portfolios that are resilient in the face of surprises rather than ones whose success depends on predicting them.

Crises, as painful as they are, also can create opportunities. However, the equity and fixed-income markets have reacted quickly to the headlines, and as currently priced aren’t offering any compelling new top-down tactical asset allocation opportunities, in our view.

Our balanced portfolios remain positioned with (1) a small overweight to global equities, coming from our tactical overweight to EM stocks; (2) a large overweight to flexible, actively managed, credit-oriented fixed-income and floating-rate funds; (3) core positions in lower-risk and diversifying marketable alternative strategies; and (4) a large underweight to core bonds, but still meaningful allocations in our most conservative portfolios.

The Gardner Group is confident that our long-term, team-driven investment process, research depth and discipline, and access to exceptional managers will enable us to continue to navigate whatever macro and market environments come our way. We can all hope whatever comes next is not as grim as a pandemic or war. But as investors, we need to be prepared for worse, even as we hope for better.

As always, we thank you for your trust, and we welcome questions you may have about the investment environment or your portfolio.