by Jordan Hucht, CFP®, ChFC®, AIF®

After a first quarter that brought plenty of pain for stocks and bonds alike, we now head into the year’s second stanza with many questions still unanswered in a song very much still being written.

At the beginning of the year, the primary concerns on the minds of investors surrounded the tightening path the Fed would take and its subsequent effect on economic growth and corporate profits. Said simply, can the Fed curb inflation by tightening policy without derailing growth in the process? Though the Fed’s general policy path has now been forecasted, the latter part of the question looms large, as do several new concerns born during the past three months.

Let’s recap.

After a year (2021) with abnormally low volatility, the first quarter of 2022 quickly extinguished that cozy fire. As the benchmark 10-year Treasury yield began climbing to multi-year highs in anticipation of the Fed’s tightening cycle, the equity markets sold off, led to the downside by “high-flying” stocks having a reckoning with the reality that money won’t be free forever. Then Russia invaded Ukraine, stoking new concerns and compounding inflation problems, thus making the Fed’s tightrope walk even tighter.

More recently, we’ve seen parts of the yield curve invert, most notably the widely watched spread between 10- and 2-year Treasury yields. Yield curve inversions occur when interest rates on long-term bonds fall below rates on short-term bonds, opposite of a “normal” environment. This happens when there is more demand for longer-term bonds than shorter-term bonds, thereby raising prices and reducing yields on longer-term bonds (bond prices and interest rates have an inverse relationship). Historically, yield curve inversions have been a predecessor to recessions, so naturally, many pundits have now jumped on that narrative.

Though equities staged a late-quarter rally, we saw a peak-to-trough drawdown of 13% on the S&P 500 (and worse on the tech-heavy Nasdaq). It was the sharpest selloff since the early stages of the pandemic, but as noted in my recent video, still very much within the constraints of normal volatility from an historical perspective. Perhaps less common, though, was the nearly 6% decline in fixed income, as measured by the Bloomberg US Aggregate Bond index. To understand why, look no further than the yield on the 10-year Treasury, which jumped from 1.5% to 2.5% during the quarter, a significant change in a short period of time.

On the economic front, strong gains in the labor market continued, with the unemployment rate dropping to 3.6%, essentially where it was in February 2020, just before the pandemic. Notably, though, the labor participation rate – a measure of the amount of people seeking employment – remains below pre-pandemic levels, meaning there are still fewer people employed now than before the pandemic, even though the unemployment rate is the same.

So what’s next?

We’re in a transitional period. In response to the pandemic, record levels of fiscal and monetary support spawned the intended economic recovery, but also surging asset prices and inflation. Now the economy (and the financial markets) must operate in a less supportive environment. Will tighter monetary policy, sticky inflation, and geopolitical concerns derail growth and put us on a path to recession? Or will a solid economic underpinning and easing supply chains aid the Fed in engineering the desired “soft landing” that brings us back to normalized rates, calmer inflation, and full employment?

My take? In the short term, I’m focused on corporate earnings, and we’re going to know a lot more as companies begin reporting their Q1 earnings over the next few weeks. But it’s not the Q1 results that really matter – it’s the guidance for the rest of the year that’ll be most impactful. Overall, strong earnings have driven the market higher, and low interest rates have supported high valuations. There was a valuation adjustment to the equity market in Q1 as higher rates made their presence known, and now we’ll see what impact the events of Q1 have had on corporate earnings outlooks.

Longer term (frankly, more importantly), I think asset allocation and diversification are key to staying on course, as there is a wide range of potential outcomes over the balance of the year and into next year. I’d expect the recent choppiness to continue as the good news / bad news tug of war plays out in the coming months. Equities, fixed income, cash, and alternatives all serve a purpose, and proper allocation across asset classes is critical to weathering volatility. Remember that volatility is a normal and necessary part of investing, and it’s likely that we’ll remain in a higher-volatility environment for some time. As always, keep a long-term perspective, and favor discipline over emotion.

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.