Earth has a nice climate compared to` other planets in our solar system. Even though temperatures often plunge to well below zero, or winds sometimes exceed 100 mph, the climate is highly supportive of life in every ecosystem. Looking at other planets in our system, however, we see temperatures ranging from -375 degrees Fahrenheit on Pluto to more than 860 degrees on Venus, or winds exceeding 1,100 mph on Neptune. In the first quarter of 2022, the capital markets faced what seemed like the worst of conditions in our solar system. The winds hitting the markets was a changed outlook from the Fed and the Russian invasion of Ukraine.

The Fed announced that rate increases would be accelerated and larger than previously expected to combat inflation not seen in 40 years. This sent rates soaring from 1.51% to 1.96% on February 24th. Also on February 24th, Russia invaded Ukraine, disrupting energy and food markets, sending prices skyrocketing. Markets reacted in predictable fashion; equity markets sold-off, while bond markets enjoyed a flight to safety. However, like the winds on the gas giants, the market winds did not relent. Because of the rise in oil and food prices, Fed governors announced that the Fed was behind the inflation curve and, to bring inflation under control, a rate increase of at least 0.5% was necessary in May, probably June and several more times this year. This sent rates higher, and the 10-year Treasury closed the quarter at 2.34%.

With this backdrop, it is unsurprising to know that stocks and bonds sold off. What might be a little surprising is the declines in equities was not as great as we would have expected knowing these events beforehand. U.S. large caps declined a tame 4.59% while small caps were down 7.8% despite the 1,100 mph winds hitting stocks. The winds hitting equities hardest are the higher rates, which increases the discount rate used to value the cash flows and earnings of companies. The best performing equities during the pandemic when rates declined are likely to be the companies that underperform as rates rise. These companies typically generate fast growing cash flows, and low rates increase the value of future cash flows. Thus, much of the value creation of the business is years away. As rates rise, future cash flows decline in value relative to near-term cash flows, and value companies with larger, slower growing cash flows become relatively more valuable. This partly explains why value outperformed growth last quarter.

We will point out that the business prospects of these growth companies are not diminished -- just the equity value and some have become more attractive as prices have declined.

Allen Trust Company outperformed our benchmark in the first quarter, as our equity holding were down 4.06%. Subtracting from performance in the quarter were Starbucks (- 21.0%), TJX (-19.8%), and Qualcomm (-16.1%). Sectors hurt performance include the underweights to energy and materials. On the other hand, companies that added to performance were Qualys (up 3.65%), Bristol Myers Squibb and Baker Hughes (up 18.9% and 52.6%, respectively). Our overweight in the healthcare and consumer staples sectors offset the underperformance in energy and materials in the quarter.

Fixed income investments were worse than equities in the quarter with the Bloomberg Agg falling 5.93%. Rising rates outweighed flight to safety trade during the quarter. It is good to report that Allen Trust Company fixed income investments outperformed the Bloomberg Agg declining 4.38%. There are two main reasons our fixed income investments fared better than the Agg. One is the high-quality bonds purchased over the past five to eight years. Secondly, in the fourth quarter of 2021 we made the decision to concentrate on individual bonds rather than funds and to focus purchases with a maturity of two years or less. Adherence to these two criteria reduces interest rate risk and avoids locking in price declines as rates rise. In rising interest rate environments, bonds decline in price, and the price of bond funds fall as well. As fund managers reallocate, price declines are locked in and will take longer to recoup than an individual bond. This is like a permanent loss, which we try to avoid with every investment. Thus, risk is reduced compared to funds, and our clients’ portfolios are benefitting.

Conclusion

The winds against the capital markets in the first quarter dented performance, but not as much as we would expect with perfect foresight. We do not expect these winds will abate soon; the volatility should continue for the next several quarters. We therefore will continue to focus on high quality investments, targeting companies with a balanced cash flow outlook, with strong and growing cash flows. Specific to fixed income, we will continue to purchase short maturities of high-quality issuers. This reduces risk in client portfolios and allows for upside as market conditions improve.

First Quarter 2022 Commentary