February 2023 Market Commentary

March 15, 2023

What a difference a month can make. January saw equity markets enjoy strong returns fueled by growing optimism that the Fed might be able to affect an elusive soft landing. In February, sentiment swung back in the other direction following disappointing inflation readings, exacerbating concerns about the Fed’s inflation fighting efforts. Those concerns were reflected in increased expectations regarding the size and number of future rate hikes. Whereas, in January markets were pricing in zero probability of a 0.50% rate hike at the Fed’s March meeting, by the end of February, those odds had increased to nearly 25%. Similarly, at the end of January, market expectations were for the Fed to carry out two additional 0.25% rate hikes, one each in March and May, and then holding steady until December at which time it would cut rates by 0.25% to end the year at a range of 4.75-5.00%. By the end of February, market expectations were for the Fed to carry out four additional rate hikes, one each in March, May, June, and September, before cutting rates once in November, to end the year at a range of 5.25-5.50%. Like 2022, rising rate expectations during the month led to broad equity market declines, with large caps (S&P 500) losing 2.6%, while small caps (Russell 2000) retreated 1.8%. International markets fared no better, with developed (MSCI EAFE) and emerging markets (MSCI EM) falling 2.2% and 6.5%, respectively.

During the second half of 2022, headline consumer inflation (CPI) steadily declined from 9.1% to 6.5%, or roughly 0.4% per month on average. In January, however, annual inflation slowed by just 0.1% to 6.4%, raising concerns that after some initial early gains in the fight against inflation, further gains may be more difficult to achieve. Currently, the largest stumbling block is services inflation which constitutes the largest portion of inflation readings, and unlike goods inflation, continues to accelerate. After peaking at 12.3% in February 2022, goods inflation decelerated rapidly, now standing at just 1.4%. Services inflation, however, has continued to increase, now standing at 7.2%. For headline inflation to make continued progress towards the Fed’s long-term target of 2%, services inflation will need to reverse course, something which will take time to materialize.

With January’s inflation readings and concerns that the Fed will have to maintain, or even increase, its inflation fighting efforts, optimism that the Fed might be able to achieve a soft landing waned. In its place, investors once again fretted about a Fed-induced hard landing, while the notion of a “rolling recession” gained traction. Under a soft-landing scenario, the Fed raises rates just enough to guide inflation back down to 2%, without triggering a recession, or a significant uptick in unemployment. Under a hard landing scenario, the Fed raises rates too quickly, and or too high, resulting in a sharp contraction in economic activity and a sharp increase in unemployment.

The rolling recession scenario posits that rather than the economy experiencing a singular broad decline in economic activity, different economic sectors contract at different times. To date, it appears this may be happening. Housing was the first proverbial domino to fall, with activity slowing sharply after the Fed began raising rates in March 2022. After leading the post-pandemic recovery, housing experienced its worst downturn since the housing crisis in 2008-09, with sales of new and existing home falling sharply, while building activity fell 27% from its post-pandemic peak. Of late, however, there are signs that the worst may be over. New home sales have increased the past two months, supply of new and existing homes has risen from record lows, and prices have begun to moderate.

In the context of the rolling recession scenario, the recession appears to be moving on to manufacturing. According to industry group ISM, manufacturing activity slowed in January to its lowest level since 2009, excluding the pandemic. The decline has stemmed in part from consumers shifting their spending back from goods to services, leading to decreased demand. A clear sign of this is new orders, which also fell to their lowest level in January, since 2009. February data showed slight improvements in both the headline and new orders data, though it’s too soon to say if that marked the bottom of manufacturing’s decline or simply a brief reprieve.

Tech may be the next sector to succumb to the rolling recession scenario, as indicated by the number of large layoff announcements in recent months by multiple industry leaders. Tech was arguably one of the largest beneficiaries of the pandemic as workers and consumers significantly altered their habits, think work-from-home, and ordering everything from cars to groceries online. In response, the Tech sector hired thousands of new employees to meet the demand. Now as work and consumption patterns normalize, the Tech sector is shedding jobs in response. Banking and Finance is another sector under some pressure as higher interest rates have led to a sharp slowdown in lending and investment banking activity. Areas that currently seem safe from recession include more service- oriented industries such as travel, leisure, and hospitality. From an outlook standpoint, we remain of the belief that by the end of 2023 the overall economy could experience a contraction but that it would be relatively modest given the current strength of the labor markets.

Fixed income markets, like equity markets, suffered losses in February as interest rates rose in response to January’s strong employment report (517K new jobs), additional solid economic data, and consumer inflation data which saw its largest monthly gain since October. In response, Treasury yields climbed during the month resulting in the Bloomberg Aggregate Bond index, the broadest measure of the US bond market, falling 2.6%. After largely dismissing the idea of further rate hikes in 2023 and pricing in up to two rate cuts before year-end, bond markets quickly adjusted on the heels of the January employment report. In addition, the January CPI data led to another uptick in Treasury yields mid-month. The turn in inflation was confirmed later in the month with PCE inflation data (the Fed’s preferred inflation measure) topping all expectations, providing a third leg up in yields to close the month. The 2-year Treasury yield rose 0.62% over the course of the month to end at 4.82%, a high not seen since 2007. The 10-year Treasury yield gained 0.42% to end at 3.92%, still a bit shy of its recent high of 4.24% reached in October of last year. The larger increase in the 2-year yield vs. the 10-year yield pushed the “2-10” spread, an oft cited recession indicator, to its widest inversion since 1981 further inflaming recession concerns.

Municipal bonds largely followed the same pattern, though the sell-off was more extreme on the short-end. Two- year AAA municipal yields had been outperforming in recent months, becoming overvalued relative to Treasury levels. When that happens, typically municipal demand subsides as investors migrate back to Treasuries, which in turn results in a subsequent increase in municipal yields. That held true in February, as the 2-year AAA muni yields jumped 0.78% to end the month at 2.93%, while 10-year AAA muni yields experienced a more muted increase of 0.40% to end at 2.62%.

Investment and insurance products and services are not a deposit, are not FDIC- insured, are not insured by any federal government agency, are not guaranteed by the bank and may go down in value.

Information and research contained herein do not represent a recommendation of investment advice to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment, and it does not constitute an offer or solicitation to buy or sell any securities. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Past performance is not a guarantee of future results. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The views and opinions expressed in this publication are subject to change, at any time, without advance notice or warning.