The month of February did not end on the same optimistic note as January did. While the markets started the year off with strong performance, the past month was more difficult as investors parsed through new data. The three major US stock indexes ended the month as follows:
- S&P 500 declined 2.60%
- Nasdaq Composite declined 1.10%
- Dow Jones Industrial Average declined 4.20%
The S&P 500 and Nasdaq Composite peaked early in the month, then worked lower as investors reacted to new economic data and adjusted their expectations for inflation and monetary policy. Labor market data revealed that unemployment fell to its lowest level in 53 years. The strong labor market has investors weighing persistent strength in parts of the economy with the lagged impact of a significant tightening of monetary policy. Consumer spending reports were unexpectedly stronger as well, supporting the narrative that the economy remains resilient while inflation remains sticky, meaning the Fed may well be higher for longer than the market expects.
The Fed will continue to be a key player throughout the year as they seek to balance their dual mandate of promoting employment with the need to bring inflation down from levels that are running well above their 2% target. The market is now pricing in a peak rate of nearly 5.5%, after which the market anticipates a full cut by the beginning of 2024. It will be critical to monitor how these expectations evolve throughout the course of the year as new cards are turned over.
Bond markets also struggled during the month, as they digested news on the inflation-front and what it could mean for monetary policy. The 10-year US Treasury yield had its biggest one-month climb since September and closed the month at 3.92%. Bond investors continue to navigate the challenging environment that inflation, the Fed, and the resilient economy are creating.
It’s clear that sticky inflation and a resilient economy are continuing to pave an uncertain path for investors.
The question of a recession is very much still top of mind, especially as the Fed’s plan for continued rate hikes, or holding interest rates at a certain level becomes more apparent. The ideal outcome is the much-discussed soft landing scenario whereby inflation cools, and the economy avoids recession, but this is not our base case. We continue to believe that it will be difficult to avoid a recession given the scope of tightening we have already seen and the work that remains to be done on the inflation-front.
For us, we view this as an opportune time to prepare while being strategic and calculated. While we don’t have control over policymakers and financial markets, we do have time-tested processes that allow our analysts to take advantage of opportunities when the time is right.
The Inflation Battle:
The Fed, investors, consumers, and businesses have spent the last year navigating extraordinarily high inflation relative to what they had become accustomed to. As we all look for it to cool, there are questions on how it’s measured, what drives it, and how it can impact investment portfolios.
We dive into the basics of inflation to help you better understand how it’s affecting markets and the economy. The battle isn’t over, and as the Fed trudges ahead, you’ll know what signs to look for, and how it’s going to impact portfolios along the way after reading our complete breakdown, Inflation 101: Your Guide to Understanding Inflation.
- Economic Cycle
- The economy is late cycle; a recession in the US is becoming increasingly likely; the Fed is on a warpath against inflation, as it found itself badly behind the curve in 2022 and is being forced by high and persistent inflation to tighten into an already weakening economy
- Stock Market
- US stock market volatility continues; market weakness has improved valuations, however, equities are not cheap by longer-term historical standards; valuations may be partly explained by robust corporate profitability, as EBIT margins have climbed to historical highs; rising input costs are posing a risk to the ability of corporations to maintain this elevated level of profitability; returns will be harder to come by and stock selection will be increasingly important
- Bond Market
- Interest rates have risen well off their lows reflecting shifting expectations on inflation, growth, and central bank policy; corporate and municipal bond credit spreads have widened, but not enough to make them materially more attractive at this time
- Important Issues on the Radar
- Inflation: a confluence of massive policy stimulus, tight labor markets, gummed-up supply chains, and rising energy costs have caused inflationary forces to broaden and become more entrenched than previously expected
- Ukraine-Russia War: an environment of elevated geopolitical risk entails a general risk-off environment, lending upward support to the dollar, gold, and commodity prices
- China’s Economy: China has pivoted on the two key economic issues that acted as severe headwinds to growth over the last two years; we will now have to see how strong and sustainable the rebound in growth will be
Sources: Wall Street Journal, Bloomberg
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