Monthly Market Recap: February 2023

In my January market recap, we discussed how markets got off to a fast start in 2023.  Looking back to 2000, US bond markets had their 4th best month on record and the S&P 500 had its 23rd best month in January.  While this was a welcome pivot in sentiment after a difficult 2022, we warned of continued risks on the horizon that markets may have been discounting.

Right on cue, we saw market performance revert lower as mixed economic data and geopolitical developments dampened investor confidence. Much like I was scrambling to buy roses and chocolates for my wife this Valentine’s Day, markets were caught wrong-footed with these new developments. 

China and Russia are strengthening ties as the Ukraine war moves into its second year and Iran is close to enriching weapons-grade-uranium.  Couple that with persistent inflation and continued uncertainty around the global economy and you have an environment where markets are highly sensitive to any new data. 

1. After a strong January, stocks and bonds struggled in February

Persistent inflation and a strong jobs report to kick off February really put a damper on a good start to the year.  Markets are concerned that inflation will remain elevated, which could drive the Fed to be more aggressive with interest rate hikes or keep rates higher for longer.  

To put it simply, higher Fed Funds Rate = higher borrowing costs = less borrowing = less economic activity = lower earnings, potential layoffs, recession (maybe).  We have discussed the concept of the Fed trying to thread the needle and navigate the economy through this rate cycle without causing a recession. Investors are very skeptical of the Fed’s ability to do this, so every piece of economic information is being highly scrutinized.  We expect this to result in continued volatility as investors look for more insight into how this tightening cycle will impact the economy. 

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2. Yield expectations are adjusting higher.

Interest rates and bond prices have an inverse relationship – higher interest rates typically result in lower bond prices. That is what we saw in bond markets after a rally in January as yields across all maturities have moved higher. Higher yield expectations have largely been driven by market projections on the path of the Fed Funds rate, which have increased since the end of January.  The yield curve remains inverted, meaning short-term yields are higher than long-term yields.

According to the Fed Funds Futures market at the end of January, markets were projecting for the terminal Fed Funds Rate to settle in the 4.75% to 5.00% range this year before dropping as we approached the end of the year.  However, as of the end of February, these expectations have been adjusted to the upside. Investors now expect the terminal Fed Funds Rate to settle closer to the 5.25% to 5.50% range or higher and will remain elevated through year-end.  This reflects investor sentiment that the Fed is having a harder time fighting stubborn inflation than initially thought and rates will likely have to remain higher for longer. 

3. Cost of shelter is rising and that could spell bad news for inflation.

The Consumer Price Index (CPI) is probably the most widely followed inflation measure in the US.  The CPI is comprised of items that consumers spend money on, and so the more of a particular good or service consumers buy, the higher the weighting of that item in the inflation calculation. Shelter represents a very large portion of the CPI calculation at just over 34%.[1]  

By now, the housing supply deficit has been widely reported in the news. There are several reasons why housing supply has not kept up with demand. Some of the main reasons include restrictions on land use and zoning, a shortage of available land and developers, and a lack of workers in the construction industry.[2] This supply shortfall coupled with high mortgage and rental rates has made shelter increasingly unaffordable in the US. Home affordability as measured by the National Association of Realtors, is at the lowest it’s been since the mid-2000 and available rental properties are largely occupied, driving up rental costs as well. 

The reason we mention this is because resolving the housing supply issue is not a quick fix.  It takes time for homes to be constructed and if costs outweigh the benefits to developers (high labor costs, high material costs, red tape), then homes will not be built.  This is why shelter is considered a part of “sticky inflation” as defined by the Atlanta Fed.  It takes time for shelter prices to revert to normal and this could continue to drive topline inflation higher for longer.

In summary, after a strong start to the year in January, markets struggled in February due to mixed economic data and geopolitical developments. Markets are concerned that inflation will remain elevated and that the Fed may respond with more aggressive interest rate hikes. This could lead to higher borrowing costs and less economic activity. Investors are skeptical of the Fed’s ability to navigate this rate cycle without causing a recession and are highly scrutinizing every piece of economic information. As a result, we expect continued volatility as investors look for more insight into how this tightening cycle will impact the economy. 

[1] “Measuring Price Change in the CPI: Rent and Rental Equivalence.” U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, February 14, 2023. https://www.bls.gov/cpi/factsheets/owners-equivalent-rent-and-rent.htm.
[2] Khater, Sam, Len Kiefer, and Venkataramana Yanamandra. “Housing Supply: A Growing Deficit.” Freddie Mac, May 7, 2021. https://www.freddiemac.com/research/insight/20210507-housing-supply.

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