Client Letter 2022 Q1

Q1 2022 Market Results

After a very strong 2021 (and 2020 and 2019) the market has pulled back since the start of 2022. After a very positive December the S&P 500 hit its all-time high on January 3, 2022, and then the retreat started. The market fell precipitously until late January, had a slight recovery into February, then fell again after the Russian invasion of Ukraine. For the quarter the S&P 500 was down -4.60%. International markets were down -6.61% in the first quarter. Emerging markets were down -6.97% for the quarter. Short treasuries were down -2.45% for the quarter.

Portfolio Thoughts

Portfolios were down across the board in Q1-2022. Equities (stocks) were down in the U.S. and internationally and bonds underperformed as well. The result is that both aggressive and conservative portfolios were down. Tactical portfolios held up relatively well considering asset class modifications and reallocations we made. Strategic portfolios were hit harder as our tactical modifications are not included there. Momentum portfolios also performed relatively well due to the U.S. exposure outperforming international investments as well as some fixed income diversification we added. Capital Preservation was hit harder because of its high level of bond exposure. Bonds did not act as a buffer for the down equity markets in the first quarter. Although the current bond environment is challenging, I feel the underlying strong U.S. economy will lead to better bond markets as the year progresses.

The world is suffering from the combination of pandemic induced supply chain issues, pandemic induced labor market problems, inflation, and now the war in Ukraine. These items together were too much for the markets. But, by the end of the quarter the S&P 500 was down far less than its low point on March 8, 2022. At that time the S&P 500 was down about 15% and we closed the quarter down less than 5%. Not a full recovery, but a noticeable uptick. I continue to believe that the underlying economy in the U.S. is strong, and we have a good chance of closing the year in the green, although nowhere as strong as the last few years. The supply chain and labor markets are improving and I believe they will continue to do so, which will have a positive impact on inflation. I expect we will be seeing these improvements more clearly by the third quarter. The one big unknown is the war in Ukraine. I don’t believe it will escalate into a direct conflict with NATO countries. But the risk of escalation is very real. With Russian forces so close to NATO country borders, a military error could draw NATO into the conflict. If NATO gets involved directly then my thoughts on the markets this year will change. For now I am staying with my base case that it does not escalate and U.S. markets will recover by year end.

Q1 2022 Notes

Without question the biggest story so far this year is the Russian invasion of Ukraine.  Let me be clear that I believe this invasion is the biggest geopolitical event of my lifetime.  Russia has decided to invade, destroy, and politically takeover, a country it feels needs to be part of its sphere of influence.  This kind of invasion hasn’t happened in eighty years.

Russia already had a high level of control in the Donbass region of eastern Urkraine, and that area is near completely surrounded by Russian soldiers.  Russian soldiers and heavy artillery are also surrounding the areas of Mariupol in the southeast and Kherson in the south.  Most analysts believe these areas are crucial to Russia building, and controlling, a land bridge from Russia to Crimea.  There is also significant bombing activity around the Ukrainian capital of Kyiv, and though the city is a shell of its former self, it has not fallen into Russian control.  Odessa, an important Black Sea port city has seen some shelling but has not yet been devastated as in other areas.  Western parts of Ukraine such as Lviv have been bombed but not to the same extent as other areas.  That could be because Lviv is not far from the border with Poland, risking escalation.  Or, it could be that Russia just hasn’t gotten there yet with heavy artillery.

The good news, as best we can understand it, is that the Ukrainian military, and even citizens, are pushing back and holding up against a vastly superior force.  Russia has more men, more guns, more tanks, and more artillery than Ukraine.  But Russian errors in planning and logistics have prevented the 72-hour full takeover many experts were expecting after the invasion.  Now we are a month into the war and Ukraine has not fallen.  NATO countries have been a huge help by sending important military equipment, mostly anti-tank and anti-aircraft weapons that have stunned Russia’s advance.  Every day that goes by makes people wonder if Ukraine could win this war.  Others believe it is only a matter of time before Russia gets its act together and ramps up its wanton destruction.  We’ll just have to wait and see.

So, what does this all mean going forward?  Well, let’s assume Russia does get its act together and starts more forcefully, and effectively bombarding Ukraine into submission.  Ukrainian President Volodymyr Zelenskyy may be forced to capitulate to Russia, give up his polity and allow Russia to control all of Ukraine’s territory.  The other option to this scenario is that NATO continues to shuttle military equipment into Ukraine and the resistance continues a long, and bloody, fight.  Given the amount of valor and courage displayed by the Ukrainians this option is not outrageous.  The second scenario is that given the high level of setbacks and losses Russia has experienced they decide to back away from the western and central areas of Ukraine and focuses on the eastern region and the land bridge to Crimea.  The logic here being that they effectively take over those areas and either formally, or informally, annex them.  The Ukrainian response here would be a difficult choice; give up territory and sovereignty or continue to fight a guerilla style resistance to retain Ukrainian territory.  Not an easy choice.

As always, we will watch and research the global economy and make investment choices to the best of our ability for each and every client portfolio.  If you have questions about your portfolio, our views expressed in this letter, or anything else financial, please do not hesitate to call.

Best Regards,

Jim