February 2023 Market Lookback

Fears of a recession were put on hold in February (at least temporarily) as strong jobs, inflation, and spending data brought attention back to the fight to restore price stability. Market participants now expect the Fed to hike three more times as opposed to one, with rate cuts no longer priced in at the end of the year. January’s decline in Treasury yields was completely reversed alongside a surge in inflation expectations, boosting the US dollar and weighing on stocks.

Macro

•   The Federal Reserve raised the fed funds rate by 25bps to an upper bound of 4.75% on Feb 1.

•   517k jobs were added in January — a significant upside surprise from the consensus +189k.

•   After a contractionary print of 49.2 in Dec, ISM Services rebounded to 55.2 in Jan, significantly above the consensus of 50.5.

•   Jan CPI came in slightly above consensus on both a headline & core basis, at 6.4% & 5.6% y/y, and 0.5% & 0.4% m/m, respectively.

•   Retail sales grew 3.0% in Jan, above consensus estimates of 2.0% on the back of a surge in restaurant spending.

•   Market pricing of the peak fed funds rate increased from 4.92% to 5.41%, with zero rate cuts now expected in 2023.

Equities

•   Bottom-up EPS estimates for the S&P 500 in 2023 declined from $225 to $222 in February.

•   Value was one of the best performing factors in February, rising 0.8% while the growth factor returned -0.1%.

•   Emerging markets slightly underperformed US stocks on the back of a stronger U.S. dollar.

•   Developed international market funds saw $7.8b in net inflows in Feb — the most since Jan 2022.

•   Large-caps, including S&P 500 index funds, saw their fourth straight month of outflows, with investors withdrawing a net $23.1b in February.

Fixed Income

•   Treasury yields rose throughout the curve in February, with the 2Y rising from 4.20% to 4.82% & the 10Y rising from 3.51% to 3.92%.

•   The move up in interest rates led to the worst month of total returns for bonds since September.

•   IG bond spreads increased to 180bps after falling to 163bps on Feb 3 — the first month of spread widening since Sep 2022.

Crypto

•   Bitcoin & Ethereum prices rose modestly, in part due to muted volatility relative to history – February’s realized volatility ranked as the third-lowest month ever.

Did That Just Happen?

What a difference a month makes. While econ data released in January pointed to disinflationary forces, February started the month swinging. Against expectations of a deceleration, the Feb 3 payrolls report instead indicated that 517k jobs were added in January — significantly above the expected 189k and nearly double December’s 260k. That amounted to an upside surprise of over eight standard deviations. To put into context how much this caught markets off guard, the probability of a three standard deviation event occurring is supposed to be 0.3%.

The hits just kept coming, with the ISM Services PMI bouncing back from marginally contractionary territory to firmly expansionary, CPI & PCE inflation measures coming in hotter than expected, and retail sales data was strong as well. The Citi Economic Surprise Index captures the sea change well, with it now at its highest level since Q2 2022 – higher readings mean upside data surprises, while lower values mean downside surprises.

While some speculate that seasonal adjustment issues might be to blame (i.e. a seasonally warm January), the magnitude & breadth of the surprises shifted the narrative during the month. The data suggests the Fed still has work to do.

Repricing for Higher for Longer…Again

Let’s remind ourselves: the Fed has raised interest rates by 450bps in less than a year. Yet besides the turmoil we’ve seen in stocks & the housing market, what impact rate hikes have had on the economy, if any, remains an open question given recent data.

Investors certainly haven’t wasted time adjusting expectations. Inflation expectations implied in Treasury Inflation-Protected Securities (TIPS) have surged since the Feb 3 payrolls report. For example, 1-year & 2-year inflation expectations increased by 138bps & 84bps, respectively, through the end of the month after the jobs print.

Market expectations of the Fed’s rate hike path moved up as well. In addition to pricing in two more rate hikes in May and June, rate cuts that were previously priced in at the last two meetings of the year are no more. The short-end of the Treasury yield curve steepened as a result – while the 3-month yield ended up rising 18bps, the 2-year rose 61bps. With an FOMC meeting & new Fed projections coming on Mar 22, there may be more repricing to come.

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