Down Month for Markets
February was a challenging month for investors as early gains were wiped out by a late-month sell-off. All three major U.S. equity indices ended up in the red. The S&P 500 lost 2.44 percent in February while the Dow Jones Industrial Average dropped 3.94 percent. The Nasdaq Composite held up the best of the three, with the technology-heavy index down 1.01 percent. Rising bond yields pressured equity valuations and performance in February.
February’s declines coincided with weakening fundamentals. Per Bloomberg Intelligence, as of March 1, 2023, with 98 percent of companies having reported actual earnings, the blended earnings decline for the S&P 500 during the fourth quarter of 2022 was 2.5 percent. While this result is slightly better than the 3.3 percent decline expected at the start of earnings season, it marks the first quarter with a year-over-year drop in earnings growth since the third quarter of 2020. Fundamental performance drives long-term market performance, so the drop in earnings growth is a potential cause for concern if weakness continues.
Despite the lack of fundamental support in February, all three major indices finished above their respective 200-day moving averages for the second consecutive month. The 200-day moving average is a widely monitored technical indicator, as prolonged breaks above or below this level can signal shifting investor sentiment for an index. All three indices remained above their respective trend lines, which is an encouraging sign that investor confidence in U.S. equities didn’t shift.
International equities had a similar month to the U.S. The MSCI EAFE Index fell 2.09 percent in February, and the MSCI Emerging Markets Index—down 6.48 percent—suffered the largest losses. Technical factors were mixed for international markets, with the MSCI EAFE Index finishing above trend while the MSCI Emerging Markets Index fell below its 200-day moving average by the end of the month.
Fixed income markets also suffered losses during the month, as rising rates negatively impacted the prices of existing bonds in February. The 10-year U.S. Treasury yield jumped from 3.39 percent at the start of the month to 3.92 percent at month-end. The notable increase in yields pressured fixed income investors as the Bloomberg Aggregate Bond Index lost 2.59 percent.
High-yield fixed income held up slightly better than investment grade in February, but investors did experience losses. The Bloomberg U.S. Corporate High Yield Index lost 1.29 percent during the month. High-yield credit spreads tightened modestly.
Inflation Fears Spark Rate Rise
Market turbulence during the month was primarily due to rising investor concerns about inflation and the Federal Reserve (Fed) following reports of higher-than-expected inflation in January. While inflationary pressure remains below the highs we saw in 2022, January’s higher-than-expected price growth is a reminder that there is still very real work that needs to be done to get inflation under control. This sentiment was echoed by the Fed, which hiked the federal funds rate 25 basis points at its February meeting. Investors anticipate further rate hikes from the Fed at its next three meetings, which could put more pressure on short-term rates.
While the higher-than-expected inflation in January is worth monitoring, it’s also important to look at contributing factors. Here we have relatively good news, as concerns about inflation were largely because economic fundamentals remain stronger than projected. January’s employment report showed a surge in hiring to start the year, as shown in Figure 1.
Figure 1. Change in Total Nonfarm Employment, February 2021–January 2023
Source: Bureau of Labor Statistics/Haver Analytics
The better-than-expected job report showed that the labor market remains healthy, as the unemployment rate also fell in February. The strong job market helped support a return to consumer spending to start the year, with personal spending and retail sales both coming in above economist estimates in January.
It wasn’t just consumers that showed signs of surprising strength, however, as service sector confidence rebounded well past estimates and into expansionary territory in January. This follows a brief, one-month drop into contractionary territory for the index and signals healthy levels of business confidence. The improvement helped support a rebound in business investment to start the year, as core durable goods orders also came in above forecasts.
While inflationary concerns remain, better-than-expected economic fundamentals are still a positive sign for investors. The odds of a recession in the short term appear to have dropped. Given the strength of the job market, the increased business confidence, and the return to consumer and business spending levels, the most likely path forward is continued economic growth.
Risks Worth Monitoring
Despite the largely encouraging economic fundamentals, there are a number of risks for investors that should be monitored going forward. Here in the U.S., concerns about the debt ceiling and a government default are rising as we get closer to a potential default in the summer or early fall. Given the uncertainty this face-off creates, it will be a widely monitored risk factor until a deal is struck.
Housing sales also continued to fall to start the year, as high prices, low supply, and high mortgage rates all worked to dampen potential home buyer demand. Given the housing sector’s importance for the overall economy, it will be an important area to monitor in the months and years ahead. The housing slowdown represents more of a long-term risk rather than an immediate concern for investors.
There are very real risks abroad that should be acknowledged. China remains a source for uncertainty, as the country’s reopening efforts have yet to be fully absorbed by the global economy. There is also the potential for additional conflict from the ongoing Russian invasion of Ukraine. While the market impact of the war largely declined throughout the course of 2022, further provocation and uncertainty is possible.
Finally, it’s important to remember that there are unknown risks that could negatively impact investors.
Outlook Still Positive
We finished the month with a combination of good and bad news, which explains the market moves we saw in February. That said, many risks are anticipated to improve in the months ahead. While prices increased more than expected in January, year-over-year inflation remains well below the highs we saw last year, and additional improvements are expected as the Fed works to constrain rising prices.
We can also expect to see some form of resolution on the debt ceiling stand-off, using history as a guide. While there is potential for short-term headline risk and uncertainty, we should see improvement over the intermediate to long term.
Of course, that’s not to say that we won’t see short-term turbulence in the months ahead. In fact, short-term market volatility is likely. On the whole, the economy and markets ended February in a relatively good place.
Given the potential for further short-term uncertainty, a well-diversified portfolio that matches investor timelines and goals remains the best path forward for most. As always, you should reach out to your financial advisor to discuss your current plan if you have concerns.
All information according to Bloomberg, unless stated otherwise.
Disclosure: Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, and Sam Millette, director, fixed income, at Commonwealth Financial Network®.
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