Quarterly Market Performance Commentary
In stark contrast to the record-setting market performance observed at the end of 2021, 2022 is off to a rocky start. For the first time since the pandemic began, COVID-19 infection concerns have cooled off and taken a back seat to new threats arising in the geopolitical landscape with the Russian invasion of Ukraine. Elected officials worldwide continue to grapple with the potential direct and indirect implications of any geopolitical decisions made, including imposing sanctions on Russia.
On March 8th, 2022, President Biden banned nearly all imports of Russian exports, with the exclusion of energy and raw materials(1), a decision that would surely impact the Russian economy. The E.U., which currently relies heavily on Russian oil and natural gas, pledged to reduce imports over the coming years. With fears that supply would quickly tighten, gas and oil prices have surged over the past month topping a new average high of over $4 per gallon for gas in the United States(2). The implications of the war, along with the accompanying sanctions, will likely continue to weigh heavy on the minds of investors and market sentiment for the foreseeable future.
While health concerns surrounding COVID-19 have begun to ease as infection rates have sharply declined, we continue to see some of the negative economic impacts. High inflation, partially caused by supply chain bottlenecks and the Federal Reserve’s actions to dampen the effects of the pandemic on the economy, increased to 8.5% in March (see Figure 1, above), the largest 12-month advance since 1981. Inflation’s influence was most notable in the increased cost of energy, which rose by 32.0% over the past 12 months(3). The Federal Reserve took its first steps in March to combat rising inflation by raising interest rates by 0.25%. This is the first rate increase since 2018, and many more are expected as officials signal a federal-funds rate target of 2% by the end of the year(4).
Domestic Equity and Fixed Income
Equity performance through the first quarter of 2022 was riddled with volatility with the S&P 500 returning –4.6%. In contrast to 2021 performance, Q1 2022 market returns were a byproduct of mounting inflation, supply chain pressures, and the Russian invasion of Ukraine. From a sector perspective, Energy dominated being the only sector returning double digits at +38.8%. The Utilities sector was the only other sector to post positive returns with gain of +5.5%. All other major sectors returned a loss for the quarter with Communication Services and Consumer Discretionary leading the way with losses of –11.3% and –9.0% respectively. See Figure 2 right for results of other S&P 500 sectors.
Historically when stocks are down, investors look elsewhere in the market for a place of refuge. Typically, these safe havens come in the form of fixed income, with the most popular often times being bonds. However, through the first quarter of 2022, the bond market wasn’t the usual refuge due to the Federal Reserve’s interest rate increase and the invasion of Ukraine(5). An increase in interest rates has a negative impact on bond returns. The Bloomberg U.S. Aggregate bond index returned –5.9% in Q1 2022 — the worst quarterly decline in the bond market since 1980. For context, bonds fell a total of -1.3% in 2021. Unease in this asset class was evident as many investors reallocated money from bonds to U.S. & International equity throughout the first quarter of 2022(6).
Investment Implications as a Result of the Russia/Ukraine Conflict
The conflict that began in February between Russia and Ukraine sent shock waves throughout the world. In a highly globalized marketplace, conflict in one country can often impact many others. In the United States, the most notable financial impact has been on certain commodities like wheat and oil. Sanctions imposed on Russia by both the United States and other western allies have severely limited the supply of oil in the world, the impact of which is most noticeable at the gas pump.
At times this quarter, consumers were paying an average price of over $4 per gallon, compared to a year ago when the average was $2.877/gallon (see Figure 3 above)(7). Without an end to the conflict in sight, many anticipate a prolonged squeeze on the supply of gas. The United States and its allies have agreed to dip into their strategic oil reserves(8), but Americans are likely to feel the impact on their wallets for weeks, and potentially months, to come.
Given the nature of this conflict, numerous large global financial institutions and sovereign wealth funds have announced their intention to divest from Russian Companies(9). In the same vein, some retirement plan participants have expressed similar interest in reallocating their investment portfolio to exclude Russian company holdings. Unfortunately, this is often times easier said than done. It’s important to note that most mutual funds, like those available in retirement plans, contain a large basket of investments with upwards of 300+ unique holdings, many of which have less than 1% total weight in the portfolio. For those who are looking to divest, there are certain asset classes which are more likely to have a larger proportion of holdings in Russian companies, including, but not limited to, Foreign Equity, Emerging Markets Equity, and International Debt funds. Forest Capital Management recommends speaking with an advisor before making any investment changes of this nature as there may be unintended consequences to excluding certain asset classes within a portfolio.
The tale of the past two quarters has been inflation—a facet of our economy that affects all without discrimination. For a short period in 2022, there was hope that inflation would soon settle to a normal rate, but those hopes have been sidelined in large part due to the war in Ukraine and its reverberated impact on commodity prices. Measured by the Consumer Price Index (CPI), inflation peaked at 7.9% in February(10), made up mostly by the rising costs of vehicles and energy, as shown in Figure 4 (right). Inflation has since increased to 8.5% in March.
In an effort to stifle inflation, the Federal Reserve raised interest rates by 0.25% in Q1 2022 and has indicated its intention to raise rates further throughout the year(11). It is within the power of the Federal Reserve to set monetary policy, thus dictating the supply of money within the economy. Even with these tools in their arsenal, many analysts expect inflation to continue for months to come, and investors should plan accordingly. While retirement savers’ investment horizon is long-term, those looking to retire in the near term may be looking for ways to hedge against inflation and can contact an advisor at Forest Capital Management for guidance.
In the closing days of Q1 2022, the retirement plan industry finally saw some movement on the legislative front. In a voting pattern that crossed party lines, the House almost unanimously passed the SECURE Act 2.0, paving the way for modernized retirement regulations. Key provisions include increasing the catch-up contribution maximum to $10,000 for employees aged 62-64, requiring all new plans to auto-enroll participants, allowing employers to match student loan repayments with 401(k) contributions, and increasing the age when retirees must begin taking required minimum distributions (RMDs) to 75 years old(12). Given how much bipartisan support the bill received in the House, it’s expected to move fairly quickly through the Senate with hopes of becoming law by year-end. Provisions are not set in stone and may change before becoming enacted; however, if SECURE 2.0 is enacted you will receive ample communication on the impacts to your plan from our team and your recordkeeper.
Evaluating Target Date Funds
Holding nearly $2 Trillion in retirement assets nationwide, Target Date Funds (TDFs) have garnered a massive stake in employee retirement portfolios. Statistically speaking, it’s likely that a large portion of your plan’s assets are allocated towards a Target Date Fund suite. How did TDFs become so popular and how should you evaluate them as a fiduciary?
Target Date Funds have been around since the ‘90s, but have seen a large spike in popularity over the last decade or so as retirement plans have adopted the asset class as their Qualified Default Investment Alternative (QDIA). Choosing a TDF suite as a QDIA is deemed a safe harbor decision per the IRS, though your responsibility for prudently choosing and monitoring the funds still remain. When evaluating a TDF suite, it is important to consider historical risk/return metrics, expenses, and appropriateness for your participant base. If ever unsure on TDF fit for your employees, consult your advisor at Forest Capital Management for assistance in running a persona analysis to identify their needs.
As with other plan investments, TDFs should be reviewed often and be supplemented with documentation of any conversation had. The maintenance of a fiduciary folder documenting decisions made is one of the best ways to mitigate the Investment Committee’s fiduciary risk.
Vesting Schedule Considerations
As the labor market tightens and companies work to retain and attract quality talent, some organizations are turning to their retirement plan as a primary recruiting tool. In reviewing the retirement benefit, many groups are paying particular attention to their employer contribution vesting schedule. See Figure 5 left for a survey on vesting schedule length variability. Choosing the right balance between attractive benefits and retention strategies is key to deciding which vesting schedule you choose.
Simply put, the shorter the vesting schedule, the more competitive the benefit and the better recruiting tool it becomes. There are instances in which a longer vesting schedule can make more sense organizationally, such as groups with larger turnover or a transitory workforce. Companies in this bucket may benefit from an elongated vesting schedule to entice greater retention and, in the event the employee does leave before they are fully vested, the employer is able to recoup some or all of those employer contributions in a forfeiture fund. Forfeiture funds can typically be used to offset plan expenses—a benefit for the employer.
Contrarily, in industries with a tight labor pool where companies are constantly fighting for talent, it may be in the company’s best interest to have a short, if not immediate, vesting schedule. When comparing job opportunities, candidates frequently compare the benefits offered. All else equal, a shorter vesting schedule will be viewed favorably by prospective employees.
Vesting schedules can typically be changed via plan amendments, although please be sure to consult your advisor before doing so. There are certain provisions that are considered protected benefits, specifically vesting schedules(13). A good rule of thumb is that it is typically easier to accelerate a vesting schedule than it is to lengthen it. If you are interested in benchmarking your plan’s vesting schedule, please contact your Forest Capital Management advisor.