Key Points

• February Flip Flop. A seasonal slowdown, reaccelerating inflation, decelerating earnings, and a rising dollar all conspired in February to reverse some of January’s gains… which itself was a reversal of 2022 trends. Dizzy yet?
• Inflation Reacceleration. February was marked by hotter-than-expected inflation data, including the Core PCE Price Index, the Fed’s preferred inflation gauge, which hit its fastest sequential pace since June 2022. 
• Dollar May Not Be Done. After depreciating from October through January, the U.S. dollar posted its strongest month since September 2022, a headwind for non-U.S. assets, particularly for emerging markets.

Market Summary

Asset Class Total Returns

Source: Bloomberg, as of February 28, 2023. Performance figures are index total returns: U.S. Bonds (Barclays U.S. Aggregate Bond TR), U.S. High Yield (Barclays U.S. HY 2% Issuer-Capped TR), International Bonds (Barclays Global Aggregate ex USD TR), Large Caps (S&P 500 TR), Small Caps (Russell 2000 TR), Developed Markets (MSCI EAFE NR USD), Emerging Markets (MSCI EM NR USD), Real Estate (FTSE NAREIT All Equity REITS TR).

This time last month, in this very space, the discussion was all about a welcome rebound across virtually all asset classes, fueled by hopes that the Fed and other global central banks were near the end of their rate hiking cycles. But as February progressed, economic data increasingly showed that global economic activity remained resilient, and inflation appeared to be reaccelerating. As a result, the “good news is bad news” dynamic that characterized much of 2022 returned and bond yields surged while most equity markets declined.

We concluded our update last month with the idea that, despite the impressive and broad rally in January, we weren’t out of the woods yet. The pullback in February seems to corroborate that sentiment, that all the pressures which hampered capital markets in 2022 will continue to be challenged in 2023. Still, barring any geopolitical surprises or exogenous events, it does appear the worst may be behind us. The February pullback only reversed some of the impressive January-to-mid-February rally, and year-to-date gains are still nicely positive for most major asset classes.

For domestic equities, that meant the S&P 500 Index fell -2.6% for the month, after hitting its highest levels since last August early in February. Smaller companies fared better, with the Russell 2000 Index losing -1.8%. The tech-heavy Nasdaq led in the down month, only giving up -1.1%. Developed international stocks were down similarly, with the MSCI EAFE Index sliding -2.3%. Emerging Market stocks were hit the hardest in February, with the MSCI Emerging Markets Index slumping -6.5%. It was the fourth down month in the last six for emerging market equities, which suffered from a rising U.S. dollar (many emerging market companies have U.S. dollar-based debt, so a rising dollar means higher interest burdens for them) as well as a -9.9% pullback in Chinese stocks, the largest component of many emerging market indices.

Returning to the macroeconomic landscape and the “good news is bad news” theme, February saw several better-than-expected reports. It started right out of the gates with the February 3rd release of the January employment report. That brought a massive upside surprise of new nonfarm payrolls that was more than double expectations and a surprise decline in the unemployment rate. But it was the mid-month release of inflation and retail sales that really caught investors’ attention. Year-over-year inflation, at both the consumer and wholesale levels, were hotter than expected. That was quickly followed by retail sales for January which was far above consensus estimates. Later in the month, consumer sentiment for February was unexpectedly revised higher, personal spending for January beat expectations, the Fed’s preferred inflation gauge (Core PCE) was higher than expected, and at the end of the month service sector activity came in at the highest level since last June.

Not all the data was stellar. The Leading Economic Index continued to slide and sits at levels that historically indicated recession, Q4-2022 GDP was unexpectedly revised lower, and consumer confidence fell to its lowest level in three months. Still, the balance of economic data was strong enough to push market expectations for Federal Reserve policy well higher. At the end of January, markets were pricing in a Fed Funds terminal rate of 4.89% in June 2023. By the end of February, the terminal rate moved both higher and longer, with an expected peak rate of 5.47% in September 2023. The benchmark 10-year U.S. Treasury note yield rose +41 basis points (bps) during the month to 3.92%, and 2-year U.S. Treasury yield surged +61 bps to 4.82%. Short-term rates really took off with the higher Fed Funds projections, with the 6-month U.S. Treasury yield crossing above 5.0%, levels not seen since 2007. Of course, bond prices move opposite of bond yields and the Bloomberg U.S. Aggregate Bond Index fell -2.6% for the month.

The “higher for longer” reset in rate expectations wasn’t just a U.S. phenomenon. Rate expectations also surged in the U.K. and the Eurozone. The surge in yields, combined with a stronger U.S. dollar, was a double whammy for non-U.S. bonds, and the Bloomberg Global Aggregate Bond Index ex U.S. sank -4.0% in February.

The Fed’s battle with inflation likely won’t be quick or easy and markets are finally beginning to price in that reality. The good news is that we are probably much closer to the end of the Fed’s hiking cycle and markets have always been able to overcome past tightening cycles. For investors with a long-term horizon, today’s dramatically higher yields make bond investments more compelling than they’ve been in years and equities are at lower valuations compared to last year as well. At some point, good news will become good news again, and on balance, the data in February improved the odds that the economy can avoid a deep or protracted recession.

Source: Bloomberg, as of February 28, 2023.
Price Returns for Equity, Total Returns for Bonds.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Quick Takes

SEASONAL SLOWDOWN

According to Carson Investment Research, as of Valentine’s Day, 2023 was the eleventh best start to a year ever for the S&P 500 since 1950, with a rise of +7.7% for the index, and a total return of +7.9% with dividends reinvested. Unfortunately, from Valentine’s Day through the end of February, the S&P 500’s price was down -4.0%. However, historically the back half of February is one of the seasonally weakest periods of the year for stocks. And in 2023, with some unexpected inflationary pressures (and therefore a still hawkish Fed), decelerating earnings growth, and a still strong U.S. dollar, that seasonal weakness in late February left the index down -2.6% for the entire month, but still up +3.4% for the year. The Carson analysis shows that in 9 of the 10 years that started stronger than 2023, the S&P 500 rose higher than the rest of the year by an average of +10.8%. 

The Latter Half of February is Seasonally One of the Weakest Times of The Year
S&P 500 Index Returns In February (1950 – 2022)

Source: Carson Investment Research, FactSet.

JANUARY GIVETH AND FEBRUARY TAKETH AWAY

This a repeat chart from January, simply updated to add the February returns for each group of assets. It shows how many of the biggest losers for the calendar year 2022 had the biggest gains in January 2023. And now it reflects how February was basically a return to trends that dominated 2022, which repealed some of the rebound experienced in January. Importantly, it was only a partial pullback of the January rally, and the 2023 year-to-date (YTD) returns maintain healthy gains – the details of which can be seen in the Market Snapshot table above. The sole exception to this is non-U.S. bonds which are marginally negative YTD (most client portfolios do not have exposure to non-U.S. bonds, a tactical portfolio adjustment made in early 2022).

Trading Places
Return Reversals: 2022 vs January 2023 vs February 2023

Source: Bloomberg.

INFLATION REACCELERATION

On February 24th, the Fed’s preferred inflation gauge, the Core PCE Price Index, was reported for January. In addition to being higher than expected, the report also saw the prior month revised higher. The January data was the fastest sequential pace since June 2022. Year-over-year, Core PCE was 4.71%, well above the Fed’s 2% goal, even after hiking Fed Funds rates to 4.75%. The hotter-than-expected inflation data resulted in futures markets suddenly pricing in a 25% chance of a 50 bps rate hike in March. Unfortunately, many ‘sticky’ components of core services will likely make it a long and challenging process for the Fed to get inflation back down to its 2% goal.

Fed’s Preferred Inflation Measures Remains Elevated
Fed’s 2% Inflation Target still far away for PCE

Source: Bloomberg.

EARNINGS DECELERATION

Earnings season for the fourth quarter of 2022 is nearly complete with 99% of S&P 500 companies now reported. And according to data from Bloomberg, U.S. corporate profits continue to fall. Earnings growth for the S&P 500 has fallen to -2.55% for Q4-2022, marking the first negative quarter since Q3-2020. And the next two quarters are estimated to be even more negative, before turning back to positive growth in Q3-2023.

U.S. Corporate Profits are Falling
S&P 500 Year-over-Year Earnings Change (%)

Source: Bloomberg.

DOLLAR MAY NOT BE DONE

The U.S. dollar reversed course in February and climbed to its highest level for the year. The Bloomberg Dollar Spot Index gained +2.6% in February, which was its best, and only positive, month since September of last year. The rise came as a result of the increased expectations for future Fed rate hikes and the unexpectedly strong labor and inflation data during the month.

U.S. Dollar’s Best Month Since September
Bloomberg Dollar Spot Index, Monthly Change (%)

Source: Bloomberg, Isabelnet.com. Pricing as of 02/02/2023.

GEOPOLITICAL RISK SUBSIDING

The Russian/Ukraine War marked its one-year anniversary during the month. Despite the lack of a resolution to the conflict and other international tensions, one measure of geopolitical risk has eased back to its long-term average. As shown in the chart below, the Federal Reserve’s Geopolitical Risk Index is back at levels close to its usual long-term range. To be sure, there are no shortage of potential international flashpoints, but there never really is. Geopolitical risks are a constant for investors, but it is encouraging to see some indications, such as this index, showing that risks are not necessarily higher now than they’ve typically been in the past.

Geopolitical Risk Normalizing
U.S. Federal Reserve Geopolitical Risk Index

SSource: Charles Schwab, Macrobond, Board of Governors of the Federal Reserve System as of 2/10/2023.
Note: Index level of 100 represents the baseline for the index.

Asset Class Performance

The Importance of Diversification. Diversification mitigates the risk of relying on any single investment and offers a host of long-term benefits, such as lowering portfolio volatility, improving risk-adjusted returns, and helping investments to compound more effectively.

Source: Bloomberg.
Asset‐class performance is presented by using market returns from an exchange‐traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees for and do not necessarily represent performance of specific mutual funds and/or exchange-traded funds recommended by The Retirement Planning Group. The performance of those funds may be substantially different than the performance of the broad asset classes and to proxy ETFs represented here. U.S. Bonds (iShares Core U.S. Aggregate Bond ETF); High‐Yield Bond (iShares iBoxx $ High Yield Corporate Bond ETF); Intl Bonds (SPDR® Bloomberg Barclays International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares U.S. Real Estate ETF). The return displayed as “Allocation” is a weighted average of the ETF proxies shown as represented by: 30% U.S. Bonds, 5% International Bonds, 5% High Yield Bonds, 10% Large Growth, 10% Large Value, 4% Mid Growth, 4% Mid Value, 2% Small Growth, 2% Small Value, 18% International Stock, 7% Emerging Markets, 3% Real Estate.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.

Chris Bouffard is CIO of The Retirement Planning Group (TRPG), a Registered Investment Adviser. He has oversight of investments for the advisory services offered through TRPG.

Disclaimer: Information provided is for educational purposes only and does not constitute investment, legal or tax advice. All examples are hypothetical and for illustrative purposes only. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Please contact TRPG for more complete information based on your personal circumstances and to obtain personal individual investment advice.