February 2023 Stonemark Market Commentary

Markets started the new year with vigor as major indices rallied in anticipation of falling inflation and a more dovish Federal Reserve. However, markets were too eager and gave up much of the January returns throughout the month of February, driven largely by new economic data showing persistent inflation. Markets are now pricing additional rate hikes from the Federal Reserve and a further tightening of economic conditions in order to combat inflation, even if it means sending the economy into a recession.

February started with an FOMC meeting on February 1, where Chair Powell indicated that the Federal Reserve would be raising interest rates by 25 basis points. Markets responded positively to Powell’s commentary on the state of inflation and the economy, interpretating much of what he said as a signal for a slowing of future rate hikes. Unfortunately, this optimism was short lived as a slew of data came in throughout the month showing that the fight against inflation is likely to continue. The Consumer Price Index (CPI) is the most commonly used measure of inflation and January’s CPI number came in at 6.4% versus market expectations of 6.2%. Additionally, Core CPI, which measures inflation excluding the volatile food and energy inputs, rose by 0.4% for the second consecutive month, to a rate of 5.6 percent.

The jump in Core CPI and the stickiness of headline CPI shows that inflation is not falling at the rates that the market priced throughout the month of January. This means that the Federal Reserve is likely to continue raising rates and conducting open market operations in its war against inflation.

The focal point of the Federal Reserve’s inflation discussion in recent months has been the resilient labor market. Outside of a few concentrated pockets of the market – primarily technology – hiring has continued to be competitive, wages have risen, and layoffs remain relatively low. The February 3 jobs report was evidence of this, as nonfarm payrolls increased by over 500k for the month of January. Consensus market estimates for the report were at 187k new jobs, meaning the report came with 300k more jobs than expected. Additionally, the unemployment rate fell to 3.4%, which is the lowest level it has been since 1969.

According to the St. Louis Fed, weekly unemployment claims for the week ending February 18 also ticked down for the first time in 4 weeks, reinforcing the upward trend in employment shown in the blowout jobs report from February 3. The resiliency of the labor market is worrisome because it means that the Federal Reserve is likely to continue tightening through open market operations and interest rate hikes until the labor market starts to cool down. Higher interest rates mean a higher cost of capital, which devalues future earnings for companies, putting pressure on current stock prices. Additionally, profit margins will continue to shrink as tightening weakens the purchasing power of consumers and forces cost-cutting for corporations.

A yield curve is a line that plots the interest rates of bonds across different maturities. When discussing the “yield curve,” people generally are referencing the yield curve that plots Treasury Bills, Notes, and Bonds. A normal yield curve would be upward sloping, meaning an investor receives a higher interest rate the longer maturity their bond is. However, the current yield curve is heavily inverted, with short-term Treasuries yielding significantly more than intermediate and long-term Treasuries. The graph below shows the 10-year Treasury’s interest rate minus the 2-year Treasury’s interest rate; this curve is the most inverted it has been in decades.

What an inverted yield curve means is that the short end has risen rapidly in correlation with the aggressive interest rate hikes that took place throughout 2022. The long end, conversely, has moved much slower than the short end, causing near-term interest rates to remain well above the long term. This means that investors are worried about the future of the economy and are reducing their duration in anticipation of a potential recession.

The yield curve is one of several leading economic indicators, and an inverted yield curve has accurately predicted each of the last 7 recessions over the past 50 years. The degree of inversion does not necessarily correlate with the severity of the recession, but it is an important leading indicator that a recession is likely to happen soon. Another important leading indicator that can be used to forecast the potential of a recession is the Consumer Confidence Index (CCI), which surveys consumers about their general perception of the economy. The CCI report for February was released on the last day of the month and it came far below expectations. This is indicative of general consumers becoming increasingly wary of the economic outlook and further removed the wind from the sails of the January rally.

At the center of all of this is the Federal Reserve, who had their first FOMC meeting of the year on February 1. The minutes from the meeting showed the Federal Reserve is intently watching all pertinent economic data and is willing to act in whatever way necessary to tame inflation. Throughout February, the market has begun pricing in further rate hikes with an anticipated terminal rate of nearly 5.5% (versus the current Federal Funds rate of 4.75%). At current levels, 75 basis points of additional rate hikes are anticipated, and this anticipation has directly correlated with the pullback in equities prices in February.

The rose-tinted glasses the market wore throughout January appears to have been short-lived as the overall outlook is “higher for longer.” The inflationary economic data that was delivered throughout February means that the Federal Reserve is likely to continue to raise interest rates and to conduct open market operations to bring down the money supply. Retailers have indicated that consumers have reached their limits with price increases, which will put pressure on profit margins. Leading indicators are showing a likely impending recession within the next 6-to-12 months. With this in mind, we have defensively positioned our portfolios to better withstand turbulent times, favoring companies that are disciplined in their financial management, generate high cash flow, maintain strong profitability, and sound balance sheets. Our defensive positioning across our portfolios will continue and we will strategically allocate as necessary amidst turbulent market times.