Market Commentary - February 2023

Monthly Update

After a solid start to the year in January with the S&P 500 higher by 6.2% as interest rates fell on hopes that the Fed would soon stop raising the fed funds rate and acute inflation pressures moderated, we got a swift uplift in interest rates in February[1]. This resulted in some stock market give back of 2.6%[2]. When we look further back, the two biggest pain points of 2022 was a 40 year high in inflation that triggered the most aggressive monetary tightening in 40 years. In late 2022, as the Fed started to moderate the pace of their rate hikes, and inflation slowed on a year over year basis, it was the positive set up for the January rally on the belief that some pain relief was upon us. Early in February, though, we saw a big upside surprise in job growth, followed by sticky inflation prints and combined with hawkish talk from Federal Reserve members that resulted in a sharp rise in market driven interest rates.

The US 2-year yield in February jumped 62 basis points to 4.82%, the highest since 2007[3]. The 10-year yield was higher by 41 basis points, closing the month just under 4%, which resulted in more yield curve inversion because of worry about the economic impact of the monetary tightening[4]. Yields also rose notably in Europe and elsewhere.

While the stock market is seemingly trading off just where interest rates are going, and economists debate whether the US economy is either in a recession or not and whether it will be a no, soft or hard landing, the earnings recession has started. By the end of February, most of Q4 2022 earnings have been reported and according to FactSet, earnings per share fell 4.6% year over year. That would mark the first time since the covid driven drop in Q3 2020 that we’ve seen a decline in earnings. Also, 69% of companies have beaten earnings estimates which is below the usual trend of something around 75%[5].

The global economy is very mixed. We have modest, if any growth in the US but there are some signs of life in Europe as they ‘weathered’ a mild winter which when combined with healthy natural gas storage levels resulted in a sharp drop in energy prices. Also, the China reopening is providing hope that not only will China’s economy recover nicely from here, but it will also give a lift to the rest of the Asian region as well as Europe and South America that do a lot of business with them. In particular, South America would benefit from their commodity trade with China. As for Europe, Germany for example lists China as its biggest trading partner.

Inflation and Central Bank Responses

The scourge of the past year as we know has been inflation and the aggressive monetary response and while inflation is moderating, the stickiness of it is in focus. In February, we saw this with a slew of inflation reports from a variety of countries and regions. The January US consumer price index rose 6.4% y/o/y and 5.6% ex food and energy and that was down just one tenth for each from December[6]. While inflation is off the peak of the 9.1% level we saw last June, having it fall to the pre covid 1-2% level on a sustainable trend will prove very tough[7]. I believe something around 3-4% inflation will likely be where it settles out.

The Eurozone reported that its February CPI was higher by 8.5% with a core rate of 5.6%[8]. The former was down just one tenth from January while the latter was up 3 tenths from the month before. The UK saw 10.1% y/o/y inflation in January and a core rate up by 5.8% and while both moderated from the prior month, wage gains are just not keeping up[9]. In Japan, Tokyo said its CPI was higher by 3.4% y/o/y headline and by 3.2% ex food and energy and those are around multi decade highs if we don’t include increases in their value added tax[10].

The European Central Bank has not been as aggressive as the Fed in tightening monetary policy but they are doing so nonetheless at 50 basis point increments and quantitative tightening is about to begin, albeit starting out a modest 15b euros per month.[11] The Bank of England has a few more rate hikes left most likely and pressure continues to grow on the Bank of Japan to move out of negative rate policy and further liberalize its yield curve control policy. The Bank of Japan in April will also have a new governor, Kazuo Ueda.

The Global Economy

The US economy is a mixed bag right now. Housing is under pressure in terms of the pace of transactions as we know affordability is a major challenge for first time buyers and many mortgage holders in an existing home do not want to give up their low rate. According to Fannie Mae, about 70% of homeowners with a mortgage have a rate below 4%. The auto sector, the other very interest rate sensitive part of the economy, is fraying at the edges for subprime borrowers who are challenged by high monthly payments because of record high new car prices and higher interest rates. For some that bought a used car in the 2^nd half of 2021 might have their loan worth more than the value of their car and which is resulting in rising delinquency levels. The US manufacturing sector has been contracting for the last 4 months as measured by the ISM and S&P Global surveys and capital spending has been modest.

The positive is the 50 yr. plus low in the unemployment rate at 3.4% and coming off the very strong job growth seen in January[12]. Also, jobless claims, measuring the pace of firings, have been very low with numbers below 200k over the past month. With respect to consumer spending, though, we heard a lot from retail CEOs in their recent earnings calls about a ‘challenged’ consumer where more focus is on non-discretionary spending and less on discretionary. With an average credit card interest rate of about 20% on unpaid balances according to the Fed, the consumer is going to be more careful with their spending. With respect to wages, blue collar workers are seeing stronger growth than those white collar ones.

The China reopening story is a big deal for global growth, but it will take some time to fully develop. On one hand you have rising travel and leisure demand as many want to make up for lost time but there definitely is some PTSD for others who will still be judicious with their consumer spending. Either way, the country has finally gotten past covid and that should be good for not just the Chinese economy, led by the consumer, but also the trading partners that sell to that consumer.

Europe is sort of caught in the middle of slow US growth, the potential for faster Asian growth at the same time a war is being waged but energy prices have fallen sharply. The markets have looked at the glass as being half full for European stocks as indices there have seen a great start to the year. As of this writing, the German DAX is higher by 12.4%, the CAC by 14% and the FTSE 100 by 6.4%[13].

Credit Spreads

A big focus of mine and notwithstanding the very sharp rise in interest rates, credit spreads of corporate bonds to US Treasuries have tightened this year, joining the risk appetite of the equity markets. Any economic worries that are out there are not really being reflected in this asset class, yet. I have a close eye on the floating rate side of the bond market too as that is most vulnerable to a big move up in rates for those who didn’t hedge. There is an index that covers this, and it is the LSTA US Leveraged Loan Index. It currently trades at about 94 cents on the dollar and while down from 98 one year ago, it is up from 92 at the October lows of 2022[14].

Conclusion

While pulling back a bit after the strong January start to the year for stocks, the stock market right now seems to be most focused on when the Fed will halt its interest rate increases. While keeping rates high for a while, which is what I think is the biggest risk right now, and a decline in earnings will eventually matter, it doesn’t right now.

I talked above about the current earnings challenge but the new, higher interest rate regime we’re currently in is something that will take time to acclimate too and slower economic growth will be the result until we are able to build a higher level of household and corporate savings. Investors too have to deal with a higher hurdle rate for investment with the risk-free rate at 15-year highs.

It is for this reason that I feel it will still be a choppy year for investors and that we need to stay sober with this new rate reality. Whatever comes our way though, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is the best friend of any investor. I also want to finish by saying that there are always opportunities to take advantage of and we are constantly on the lookout for them.

Disclaimer

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[1] Bloomberg

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[14] Bloomberg