U.S. equities closed out their first quarterly loss in two years with the S&P 500 Index falling 4.9% in Q1, the first quarterly decline since the 20% plunge in Q1 2020 at the start of the pandemic. The first Fed rate hike since 2018, the highest inflation in 40 years, and the biggest conflict in Europe since WWII all weighed on investor confidence.

Large-cap U.S. stocks were not the only asset class to struggle. Small-caps, Treasury bonds, corporate bonds, developed international, emerging markets, and real estate benchmarks all fell at least 3.5% for the first time since Q3 1981, even though Treasurys were the only asset to fall more than 10%. Commodities were one of the few places to hide: The S&P/GSCI (commodity index) jumped 29.1% for its best quarter since Q3 1990 (when Iraq invaded Kuwait).

Normally, when risk-on assets like stocks and real estate fall, risk-off assets like Treasurys rally. Instead, inflation fears steadily pushed the 10-year yield from 1.51% to 2.35%, its highest level since May 2019. The 2-year Treasury also saw a rapid increase in yields rising from 0.73% to 2.33%. As a result, the U.S. bond market suffered its worst quarterly performance since Q3 1980 and the third worst showing since 1973, losing 6% (that was even worse than the S&P 500’s 4.6% loss).

While the Fed doesn’t convene again until May, some market participants are clamoring for bigger rate hikes, in the magnitude of 50 basis points, as opposed to the 25-basis point increase seen in March. By year-end, traders see a greater than 66% probability that the fed funds rate will have a target range of 2.50% to 2.75%, which would be the highest since 2008.

So where to from here?

The bullish case rest primarily on whether central banks can engineer a soft landing and avoid tightening so aggressively that it pushes us into a recession. Likewise, a favorable resolution of peace in Ukraine could also help improve market prospects. To state the obvious, we have no idea how the war in Ukraine will unfold and can only assess the likelihood of various scenarios. We think markets will continue to grapple with the trade-offs between inflation and growth and the central bank response. Most economist agree that inflation will be higher and stickier than expected. The war in Ukraine and sanctions on Russia only bolster this view, given the likelihood of additional supply-chain disruptions and shortages in agricultural, metal, and energy commodities. Higher energy prices could also weigh on economic growth and continue to be a headwind.

All in all, it adds up to a topsy–turvy investing environment where managing risk becomes paramount. As always, we will continue to monitor the economic and investment landscape and make changes accordingly.