The year’s strong start saw a bit of a reversal in February. Higher interest rates led to a decline in stocks and bonds as the latest economic data has shown both high inflation and a tight labor market appear to be sticking around. Before talking about the economic data specifically, let’s consider some index returns. The S&P 500 lost 2.4% in February bringing its year-to-date return to 3.7%. Growth outperformed value, with the S&P 500 Growth losing 1.9% compared with the S&P 500 Value losing 3.0%. Technology was the leading sector—in fact it was the only positive sector—with a 0.4% return while Real Estate and Energy lost the most with declines of 5.9% and 7.1%, respectively. The outperformance of tech, and more generally of growth over value, was somewhat surprising due to the significant increase in interest rates. Yields rose across the curve as the 2 year U.S. Treasury rate increased from 4.20% to 4.81% and the 10 year U.S. Treasury rate increased from 3.53% to 3.92% over the course of February. The increase in yields led to a strengthening of the U.S. Dollar, which appreciated significantly in February after weakening over the past several months; the strengthening dollar was a headwind for international returns, specifically emerging markets, which lost 6.5%. Bond returns were also negatively impacted by rising rates—the Bloomberg U.S. Aggregate index lost 2.6% in February, giving up most of its gains from January. 

Interest rates had been trending lower since October, so what caused the reversal? As we have written about virtually nonstop for over a year now, expectations of the Fed’s course of monetary tightening are constantly changing, and whereas from November through January the general consensus was that the Fed would soon find a place to pause hiking its Federal Funds Rate (despite comparatively hawkish guidance from the Fed), data releases in February fell more on the side of rates being higher for longer. For instance, on February 3rd the market was stunned by a massive jobs report showing that 517,000 nonfarm jobs were added in the month of January, nearly double the number from the previous month and nearly triple the 185,000 jobs analysts were expecting to see in the release. Fed Chair Powell said in comments both before and after that job report that the central bank still had work to do, and while many wrote off his comments before as posturing, the jobs report gave the Fed’s forward-looking guidance much more credibility. As if that wasn’t enough, inflation data has disappointed investors throughout February. The January CPI release on February 14 showed a year-over-year increase of 6.4% although 6.2% was expected. The month-over-month increase was 0.5%. The Fed’s preferred measure of inflation, the PCE index, was even more concerning as it showed an increase in the year-over-year rate from 4.3% to 4.7%-- not the direction you want to see prices move whether you’re the Fed or an investor. Retail sales, personal spending and consumer sentiment indicators all told the same story: the average U.S. consumer still feels comfortable spending money. 

It’s dangerous to label any one period as an inflection point for the markets—at least it is risky to do so contemporaneously—but one does get the sense that the next couple of months will be critical for adding clarity and setting the tone for the remainder of the year. This ongoing debate between those who forecast a recession and consummate decline in earnings and those who think we’re in store for the proverbial “soft landing” will be resolved sooner or later, and it will either be resolved if/when inflation data like CPI and PCE approach much closer to 2% or if/when unemployment begins to spike above 5% to recessionary levels. 

To be clear, there is some point at which Fed tightening will break the economy. The question is whether that point is higher than the point necessary to get inflation under control. Considering that inflation is being driven primarily by wages at this point (as opposed to supply chain disruptions and commodity price increases), the logical and academic answer is no. To bring down inflation the Fed needs to bring down the rate of wage increases, and that requires a slowdown in the job market. 

Of course the ultimate trajectory of the economy and the markets over the next year should be irrelevant to those invested appropriately for their circumstances. It’s great if the markets run higher from here; if they don’t then that creates an opportunity for young savers and should not impact those in or near retirement as long as they have taken care to diversify their portfolios as needed. 

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