January’s Optimism Gives Way to February’s Caution

What a Difference a Month Makes

2023 began with a bang as risk assets rose significantly and interest rates fell on the premise that inflation was moderating despite a resilient labor market and indications that the U.S. economy was potentially heading toward a “soft landing.” The start of February saw the International Monetary Fund raise its 2023 global growth forecast to 2.9% from 2.7% in October due to “surprising resilient” demand in the U.S. and Europe, reopening in China and an easing of energy costs. The U.S. Federal Reserve, however, remained hawkish and raised the fed funds rate by 25 basis points to 4.75% in early February, expressing caution that additional tightening could be warranted to bring inflation under control. The market, in contrast, was pricing in potential interest rate cuts in the back half of 2023, which underpinned the optimism in risk assets seen at the start of the year. In our view, this disconnect between the market and the Fed was in many ways similar to what took place last year when the market continued to price in more aggressive rate hikes compared to the Fed, which eventually had to play catch up. The roles reversed this year, with the market playing catch up and the Fed remaining steadfast.

Markets quickly shifted in February as resilient labor market data showed further signs of overheating. Stickier-than-expected inflation data also trickled helping major equity and fixed income indices to turn negative, albeit without completely erasing January gains.

The labor market surprised with nonfarm payrolls increasing by 517,000, their strongest gain since July, and the unemployment rate falling to 3.4%, its lowest reading since 1969. In response, Fed Chair Jerome Powell stressed that the jobs report supported the Fed’s “higher-for-longer” messaging. Initial jobless claims came in below 200,000 for the next three weeks following a hot nonfarm payrolls print, further confirming the tightness of the labor market and its upward pressure on wages. For context, jobless claims on average have tended to begin to rise 18 – 21 months after the first rate increase in a hiking cycle. However, it is worth remembering that this has been the fastest rate cycle on record, with cumulative increases of 450 basis points over 11 months.

Following Powell’s comments, key inflation data came in unexpectedly high, leading to a repricing of future fed funds hikes, reflecting a higher terminal rate, and removing the expectation of a pivot by the central bank this year. Notably, the Fed’s preferred inflation gauge, the Personal Consumption Expenditures Index (PCE), rose by 5.4% year-over-year (YoY), an unexpected jump leading to the worst week for U.S. equities (-2.7%) since early December. Retail sales, a measure tracking the sale of goods and services, added fuel to the fire, rising 3% versus and expected 2% month-over-month (MoM), confirming the strength of the consumer. Both consumer (CPI) and producer price (PPI) inflation came in above expectations for January. While our Global Fixed Income team expects CPI headline inflation (excluding food and energy) to slow materially from 6.3% (YoY) in January to about 3.3% at the end of the year, we do not expect inflation to reach the Fed’s 2% target until the back half of 2024.

Federal Funds Rate and Market-Implied Expectations

Source: Bloomberg, As of February 28th, 2023, Market Expectations are derived from Fed Funds Futures by FOMC meeting.

Looking at economic growth, U.S. Gross Domestic Product (GDP) rose 2.7% in the fourth quarter, down from a previous estimate of 2.9% and slower than the third quarter’s 3.2% gain. The Atlanta Fed’s GDPNow metric (a running proxy of GDP growth in the U.S.) is currently suggesting above-consensus 2.8% growth (annualized) for the first quarter, suggesting that the Fed could be forced to continue hiking interest rates in order to cool off the economy.

The Hot Labor Market and Sticky Inflation Hamper Markets

Equities were down across the board during February, with the S&P 500 index returning -2.4% as investors recognized that the Fed still had more work to do. Non-U.S. equities showed weakness on the back of a stronger U.S. dollar, with developed markets (represented by the MSCI EAFE Total Return Index) falling 2.1% and emerging markets (the MSCI Emerging Markets Total Return Index) dropping 6.5%. We continue to maintain an underweight view on equities given elevated valuations and the potential for further declines in earnings. That said, we are mindful of potential opportunities to add risk exposure over the course of the year.

Sizing up the fourth-quarter earnings season, S&P 500 companies saw an average decline of roughly 5% (YoY) versus an initial expectation of 3%. Excluding the energy sector, the trend was worse, with earnings down nearly 9%. Looking ahead, the consensus expectation for 2023 has decreased from 4.7% at the start of the year to 2.2% at the end of February (FactSet). This recalibration of earnings is in line with our view that the current macro environment should favor companies that are less exposed to labor and commodity costs, have more pricing power and use less aggressive accounting to calculate earnings. Overall, we envision this translating into increased dispersion of performance among stocks, potentially benefiting active managers.

Fixed income markets also posted negative returns in February, given the biggest jump in the U.S. 10-year yield since September (+41 basis points). Notably, investment grade and high yield spreads (the yield advantage over Treasuries) for U.S. corporate bonds remained relatively contained, a testament to what we see as constructive fundamentals. The uptick in rates has made yields in both areas increasingly attractive, in our view. In addition, shorter-term Treasury yields hovered above 5%. In our opinion, more stable yields, coupled with clarity on monetary policy, should help to continue bringing money flows back into bonds. We continue to have an overweight view of investment grade fixed income, with a focus on quality and shorter duration.

Commodities too were negative performers in February, broadly returning -4.7% (as represented by the Bloomberg Commodity Index). Gold hovered near two-month lows on interest rate jitters, and oil prices fell as the U.S. dollar strengthened. However, oil could potentially rebound should Russia further cut supply. While we maintain an overweight view on commodities for portfolio diversification, where applicable, recession risks could hurt short-term demand.

Portfolios: Weathering the Storm

Despite January’s strong start, February reinforces our continued belief that investors should remain cautious and defensively positioned for the time being. A higher-for-longer terminal fed funds rate, persistent inflation, the hot labor market and weaker earnings will likely challenge markets throughout the year. We continue to favor a focus on diversified, high-quality, shorter-duration assets while retaining the flexibility to add risk as potential opportunities present themselves.

 

Please contact your NB Private Wealth team with any questions about the markets or your portfolio.

Index Returns

Source: Bloomberg, total returns as of February 28, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq 100 NASDAQ-100 Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg ExEnergy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.