February 2025: Politics and Fundamentals

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February 2025: Month at a glance

Equity markets weakened in February, with US stocks especially soft. The post-election bounce that ended 2024 faded as investors grappled with uncertainty around the impact of proposed tariffs and cuts in public sector employment and spending on inflation and growth expectations. The transmission of those policies to the real economy and the markets is hard to estimate, but by the end of the month, measures of consumer sentiment and inflation expectations deteriorated sharply.¹ To be sure, current economic fundamentals, including Q4 corporate earnings, remained relatively healthy, prompting Fed officials to reiterate that they feel in no rush to cut interest rates.²

Still, some fundamental measures reported in February raised concerns. Inflation reports were mixed, with an unexpected rise in the Consumer Price Index spooking investors only to be calmed by a more benign Personal Consumption Expenditures price index (PCE) report on the last day of the month.^{3 4} Consumer spending also softened more than forecast, although some of the drop could be due to especially cold weather across the country during the month.^{5 6}  With these signs of potential weakness, longer-term interest rates declined, causing a return of the inverted yield curve recessionary warning signal.⁷

• The S&P 500 fell 1.3%, while the NASDAQ and Small Cap indices dropped even more.⁸
• International stocks, both developed and emerging, continued to outpace US indices.⁹
• Q4 earnings for the S&P were up 14.4% from a year earlier and expectations for 2025 remain high.¹⁰
• Employment gains were below expectations in January, but the unemployment rate dropped.¹¹
• Retail sales fell sharply in January, with weather related weakness in auto sales especially notable.¹²
• Inflation releases were mixed, with the CPI rising more than expected while the PCE index came in below expectations.^{13 14}
• The yield on 10-year Treasuries fell to 4.24% over the month, down 34 basis points from the end of January.¹⁵

Stocks fall on inflation and growth concerns

Stocks fell broadly in February, with weakness especially in technology stocks and economically sensitive small cap sectors. The rotation in leadership to international stocks continued during the month, pushing EAFE stocks up over 7% for the year.

• The S&P fell in February, cutting its year-to-date return in half to 1.44%.
• Developed international markets posted the best returns for the month and for the year so far.
  
  • Returns were especially strong in Europe with Germany up 4%.¹⁶
  • Chinese stocks rallied up 11.76% for the month.
• US Small Cap stocks fell sharply, reversing their strong start to the year.¹⁷
• Defensive sectors fared best while technology stocks continued to lag.¹⁸
  
  • Consumer staples stocks rose 5.7%
  • Healthcare stocks continued to rebound and are now up over 8% for the year.
  • The economically sensitive consumer discretionary sector fell 9.37% for the month.

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Fed holds tight, but long rates fall

Despite Fed comments on holding short term rates steady, longer dated yields fell steadily during February. Declining yields bolstered fixed income returns across the board for the second consecutive month.  

• All major fixed income sectors reported positive returns in February, with broad sectors leading the way.²³
• The “barbelled” ultra short and riskier segments posted the weakest returns for the month.
• Inflation fears continued to bolster TIPS returns.
• International bonds, especially emerging market debt, have had a solid start to the year.

Sentiment declines are highly political…

Investors continue to weigh the potential impact of proposed tariffs, job cuts across the public sector and potentially deep cuts in government spending across a range of sectors. While many of the policies of the Trump administration are still being formulated and also facing legal challenges, the broad directions are clear. The fears for many investors are that the policies will re-ignite inflation and potentially lower growth, concerns that differ markedly by political party. Of course, the actual net impact over a mid to long-term horizon is harder to predict as consumers adapt to changes in prices for impacted goods in ways that may lessen inflationary pressures and declines in government spending potentially lower the pressure coming from the current record level of federal debt.

Regardless of the actual impact on inflation and growth, equity investors dislike the added uncertainty after a period of lowering inflation and strong, if uneven, economic growth. As a result, various measures of consumer sentiment have deteriorated sharply recently. The widely cited University of Michigan Consumer Sentiment Survey showed a sharp drop in its broadest measure in January and February, sliding nearly 10% from January levels.²⁴  The decrease was consistent across age, income, and wealth groupings, but, in a continued sign of our politically fractured times, while sentiment fell for both Democrats and Independents, it was unchanged for Republicans. This split is a complete reversal from prior to the election when Democrats and Independents reported positive sentiment for economic conditions while Republicans felt much more pessimistic.

The survey also showed the second consecutive especially large jump in inflation expectations over the next year. Year-ahead inflation expectations jumped to 4.3% in February, a full percentage point higher than January and the highest reading since November 2023. Similarly to the broader sentiment measure, while February’s increase was seen across income and age groups, inflation expectations rose for Independents and Democrats, but fell slightly for Republicans.²⁶

Given the deterioration in sentiment, it’s not surprising that investors' outlook for the stock market over the next 6 months has become much less optimistic. The percentage of the American Association of Individual Investor weekly survey respondents who expect market declines in the next 6 months (“bearish outlook”) jumped to over 60% in February, a 26% increase from the end of 2024 and the highest level since September 2022.²⁸ The AAII survey does not measure responses by political party, but one can assume that the results would show a similar split to those seen in the Michigan surveys.

…but it’s ultimately about growth and inflation

As you can see in the graphs, these survey-based sentiment measures are quite volatile month-to-month (and week-to-week for the investor survey). In addition, the evidence is mixed on whether these measures produce accurate forecasts of future economic and market activity. The University of Michigan survey is indeed used in the US Leading Economic Indicators series from the Conference Board and some researchers have found them useful in predicting near term changes in economic activity.^{30 31} On the other hand, the AAII Investor Survey has often been cited as more of a contrarian signal, at least for pessimistic readings, with high bearish sentiment leading to rising stock prices in the subsequent six months 66.3% of the time.³² These mixed results combined with the very different readings based on political affiliation should introduce some skepticism in extrapolating from the signals in the current environment.

Still, the rapid deterioration in these measures combined with other actual economic data is a part of the mosaic. Reported inflation has crept back up in the past several months, albeit slowly and ticking down in February for the Fed’s preferred PCE price index as seen in the chart below. Progress on inflation is a key determinant of the likelihood that the Fed will resume lowering interest rates. In addition, the most recent consumer spending reports for Personal Consumption Expenditures (chart below) and retail sales show modest declines. The path of consumption is of course the key determinant of overall economic growth.

Much of the shift in sentiment is attributed to the projected impact of tariffs and public sector layoffs and federal spending cuts. Trying to gauge that impact is difficult. Apollo Global Management’s chief economist recently estimated the impact of tariffs, layoffs and spending cuts on GDP and inflation using a model similar to the Fed’s model of the US economy and found that “over the coming quarters, inflation will be 0.2% higher and GDP will be 0.5% lower”. In his words, “a modest stagflation shock to the economy but not a recession”.³⁵ The 0.2% higher inflation prediction is much less than the 1% increase inflation expectations seen in the Michigan survey.

Other measures used to forecast economic growth show some modest indications of rising recession risk. When longer dated treasury yields are lower than shorter term treasury yields the yield curve is said to be “inverted”. Periods of inverted yield curves (i.e., negative spreads) have preceded each recession since World War II.³⁶ That is until the current environment where a long stretch of inversion did not lead to a recession. The yield curve returned to a positive spread in December, but fell back to negative territory at the end of February. It is possible that the inverted yield curve signal will finally prove accurate in forecasting a recession, but it is also understandable to be skeptical.

Another useful forecasting gauge is the Conference Board’s index of Leading Economic Indicators (LEI).³⁸ Historically, when the six-month change in the LEI has fallen below -5%, it has been a predictor of a recession. But, like the inverted yield curve signal, it has not proven reliable in the current period as the signal fell below -5% from mid-2022 to the summer of 2024 with no recession. Despite a drop in the monthly LEI in January, the six-month growth rate continues to trend upward. So, while the measure remains in the recession “warning” state (when the six-month growth rate is below 0), it is no longer predicting an imminent recession.

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Leading Economic Indicators:  6-Month Growth Rate

It is most likely that the impact on economic growth and inflation from the Trump administration’s policies will neither be as negative as many Democrats fear nor as positive as many Republicans hope. The reality is that inflation continues to prove difficult to bring down to the Fed’s 2% target and that the US economy, while softening in some areas, remains relatively solid. Amidst these conditions, the recent shifts in sentiment reflect increased uncertainty as the details of new policies emerge and investors weigh their pros and cons. This uncertainty combined with lofty equity valuations in many sectors of the market, leaves stocks vulnerable to the kinds of declines and rotations we saw in February. Whether these shifts are just a near-term correction or the start of a broader bear market will depend less on politically bifurcated sentiment and more on the fundamental drivers of economic growth.

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Atomi Financial Group, Inc. dba Compound Planning (“Compound Planning”) is an investment adviser registered with the Securities and Exchange Commission and based out of New York. The views expressed in this material are the views of Compound Planning through the period ended February 28, 2025 and are subject to change based on market and other conditions. 

This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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[1] http://www.sca.isr.umich.edu/
[2] https://www.reuters.com/markets/rates-bonds/feds-jefferson-says-fed-can-take-time-next-interest-rate-decision-2025-02-19/
[3] https://www.bls.gov/news.release/cpi.nr0.htm
[4] https://www.bea.gov/news/2025/personal-income-and-outlays-january-2025
[5] https://www.census.gov/retail/sales.html
[6] https://www.reuters.com/markets/us/us-retail-sales-fall-sharply-january-2025-02-14/
[7] https://fred.stlouisfed.org/series/T10Y3M
[8] https://www.spglobal.com/spdji/en/index-family/equity/
[9] https://www.spglobal.com/spdji/en/index-family/equity/
[10] https://www.spglobal.com/spdji/en/documents/additional-material/sp-500-eps-est.xlsx
[11] https://www.bls.gov/news.release/empsit.nr0.htm
[12] https://www.bea.gov/data/gdp/gross-domestic-product
[13] https://www.bls.gov/news.release/cpi.nr0.htm
[14] https://www.bea.gov/data/personal-consumption-expenditures-price-index
[15] https://fred.stlouisfed.org/series/DGS10
[16] https://www.msci.com/end-of-day-data-search
[17] https://www.spglobal.com/spdji/en/index-family/equity/
[18] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices
[19] https://www.spglobal.com/spdji/en/index-family/equity/
[20] https://www.msci.com/end-of-day-data-search
[21] https://www.nasdaq.com/market-activity/index/comp/historical
[22] https://www.spglobal.com/spdji/en/index-family/equity/
[23] https://www.spglobal.com/spdji/en/index-family/fixed-income/
[24] https://www.sca.isr.umich.edu/
[25] https://fred.stlouisfed.org/series/UMCSENT
[26] http://www.sca.isr.umich.edu/
[27] https://fred.stlouisfed.org/series/MICH
[28] https://www.aaii.com/latest/article/259032-aaii-sentiment-survey-pessimism-launches
[29] https://www.aaii.com/sentiment-survey
[30] https://www.conference-board.org/topics/us-leading-indicators
[31] https://www.brookings.edu/articles/the-predictive-power-of-the-index-of-consumer-sentiment/
[32] https://optionalpha.com/podcast/predictive-power-of-investor-sentiment
[33] https://fred.stlouisfed.org/series/PCEPI
[34] https://fred.stlouisfed.org/series/PCE
[35] https://www.apolloacademy.com/a-modest-stagflation-shock-but-not-a-recession/
[36] https://people.duke.edu/~charvey/research_term_structure.htm
[37] https://fred.stlouisfed.org/series/T10Y3M
[38] https://www.conference-board.org/topics/us-leading-indicators
[39] https://www.conference-board.org/topics/us-leading-indicators