Market Commentary: February 2023

At a Glance

• Stocks and bonds fell in February on less progress on inflation reduction
• The tech sector was the only segment to show positive gains over the month
• Inflation rose in January and expectations remain above the Fed’s target
• Economic activity remains solid, but recession indicators are flashing red

Are we there yet?

After a strong January, equity and fixed income markets fell broadly in February. Investor optimism on easing inflation leading to a less hawkish Fed was challenged by still high price increases, tight labor markets and solid consumer spending. While many economic signals show deceleration, investors are rightly focussed on whether the pace of that deceleration is enough to put the Fed into a more neutral monetary policy stance. The Fed did indeed ratchet down the level of rate increases, raising the Fed Funds target rate 25 basis points at its February meeting, but also signaled that “a couple more rate hikes” are coming to get the rate to just above 5% in order to tame inflation that remains above the Fed’s target.^1 2 Longer term rates rose as well, with the 10-Year Treasury yield up 40 basis points over the month.³ A potentially higher path for interest rates than expected is what spooked the equity and bond markets in February.

Equity Returns: February 2023 and 2023 Year-to-Date

Equity markets fell during the month, with the S&P 500 index down 2.44% and the Dow off 3.94%.⁶ The NASDAQ continued to lead broader indices, falling just over 1% for the month.⁷ Only the technology sector managed to post positive returns for the month (up just 0.29%) while last year’s leaders, energy and utilities, fell sharply.⁸ International markets fared worse than the US, with emerging markets especially weak, off 6.67% for the month. ⁹

Fixed income markets also declined, with all but the shortest term treasuries posting negative returns for the month. Corporate bonds, both in the US and Internationally, fell over 3% for the month, almost wiping out their gains from January. Preferred stocks, which posted double digit gains in January, fell modestly in February, but remain up almost 10% for the year.¹¹

Easing inflation, but is it enough? 

Inflation measures are well off their highs from earlier this year, but the pace of decline has slowed in the past few months and prices in January increased from the prior month. The core CPI (less food and energy) rose 0.4% in January from December, but remains 5.6% above last year’s level. ¹² The Fed’s preferred inflation gauge, the Personal Consumption Expenditures price index, also rose in January from December and is now up 5.4% from a year earlier.¹³ As the table shows, both of these measures are well off the highs reached earlier this year, but investors are concerned that the pace of the year-over-year declines have slowed. Part of the issue the Fed is facing when trying to bring down inflation is higher prices (and wage gains) becoming entrenched in consumers’ and workers’ expectations. The February University of Michigan survey showed consumers expect 4.1% inflation over the coming year, down from last April’s peak of 5.4%, but disappointingly up from January’s 3.9% level.¹⁴ It is this gap between 4% inflation expectations and the Fed’s stated 2% target that has investors worried that the Fed will have to keep rates higher for longer.

Current and Expected Inflation

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Source: Bureau of Labor Statistics, Bureau of Economic Analysis, Federal Reserve Bank of Cleveland, University of Michigan^{15 16 17 18}

The tighter monetary policy has so far not resulted in an official recession. Consumer spending has remained strong, up 3% in January from December and 6.4% from January 2022.¹⁹ Labor markets also remain tight. With 97% of S&P 500 companies reporting, Q4 2022 corporate earnings are showing some weakness and expected to be down 1.7% from Q3 and guidance for the current quarter are trending lower.²⁰ Other indicators of economic activity are suggesting a broader slowdown. The index of leading economic indicators fell further in January and is indicating a likely recession in 2023.²¹ Another favorite recession indicator, the spread between 10 year and 3 month (or 2 year) treasuries is also indicating challenges. A negative spread (that is, higher short term rates than long term) is termed an inverted yield curve and has often been associated with a coming recession. The current spreads are close to -0.9% and have been negative since the middle of 2022.²² Still, Campbell Harvey, the economist whose research demonstrated the relationship, thinks that the tight labor market and strong consumer and corporate balance sheets could help the economy avoid recession this time, unless the Fed does not wrap up the current cycle of interest rate increases.²³

For markets and investors, the focus will remain on the path of moderating inflation, the income and spending of consumers and the resulting corporate earnings delivery. Even more importantly, the attention will center on how the Fed reacts to developments in these areas. It’s clear that a more dovish Fed and a soft landing or mild recession is baked into equity prices. If either of those dimensions show signs of worsening then asset prices will have to fall further to adjust.