March 2023
US Economy: Inflation persists.
After an uptick in January, US inflation is running at 6.4% annualized (Consumer Price Index) and 5.4% (Personal Consumption Expenditures). While consumer confidence and spending (+1.8% in Jan.) remain strong, wages are not keeping up with inflation, and debt is on the rise. Consumers in their 30s have already increased their debt levels 27% since the onset of Covid, the fastest pace since the ’08 recession.
US Stocks: Widespread volatility.
Although tech stocks (+0.5%) generally held up well in February, equity markets gave back a good portion of 2023 gains on disappointing inflation data and potential for the Fed to continue raising interest rates. Volatility in the US Treasury bond market (MOVE Index) jumped 24% to more than 123 (historical average is 91). Stock market volatility rose past 20 (VIX Index), after hitting a 12-month low.
Foreign Stocks: Mixed results.
The US dollar, which had been weakening since October, spiked during February on expectations that US interest rates would stay elevated for longer. A stronger dollar detracted from foreign market results, but slightly better inflation data and corporate earnings in the Eurozone boosted returns relative to the US. Germany (-1.8%) outperformed slightly despite economic activity declining to pre-Covid levels.
Fixed Income: Safe and short.
Given the ongoing rise in US interest rates, savings accounts and short-term debt instruments were the leaders in February, with the 3-month US Treasury bill up 2.7%. Municipal bonds lost ground (-2.4%), even though they are typically less sensitive to rising Treasury rates, as did high-yield bonds (-1.3%) despite their attractive relative payouts. Non-US debt issued in foreign currencies was hurt by dollar strength.
Real Assets: Surprise downshift.
Commodity prices typically benefit from higher-than-expected inflation but that was not the case across the board in February. Gold was the key commodity that managed to eke out a gain, but a warmer than usual winter drove down demand for oil (-2.3%) and natural gas (-6.6%). Meanwhile, the potential for an economic slump hurt both infrastructure equities and Real Estate Investment Trusts (REITs).
Alternatives: Limiting downside.
Hedge fund strategies continued the modest or flat performance that made them relative winners in 2022 and again in February. In the private market arena, which tends to be less liquid and slow to adjust valuations, 2022’s downturn has started to be reflected in lower asset pricing and created new opportunities. This is especially the case in the “secondary” market for private equity, as equity owners needing to raise cash are willing to sell at a discount.
Source of data: Bloomberg
Equities Total Return
| FEB | YTD | 1 YR | |
|---|---|---|---|
| U.S. Large Cap | (2.4%) | 3.7% | (7.7%) |
| U.S. Small Cap | (1.7%) | 7.9% | (6.0%) |
| U.S. Growth | (1.2%) | 7.2% | (13.0%) |
| U.S. Value | (3.5%) | 1.8% | (3.0%) |
| Int’l Developed | (2.1%) | 5.8% | (3.1%) |
| Emerging Markets | (6.5%) | 0.9% | (15.3%) |
Fixed Income Total Return
| FEB | YTD | 1 YR | |
|---|---|---|---|
| Taxable | |||
| U.S. Agg. Bond | (2.6%) | 0.4% | (9.7%) |
| TIPS | (1.4%) | 0.4% | (10.4%) |
| U.S. High Yield | (1.3%) | 2.6% | (5.5%) |
| Int’l Developed | (1.0%) | 0.2% | (11.0%) |
| Emerging Markets | (0.3%) | 0.7% | (0.2%) |
| Tax-Exempt | |||
| Intermediate Munis | (2.0%) | 0.0% | (2.6%) |
| Munis Broad Mkt | (2.4%) | 0.6% | (5.5%) |
Non-Traditional Assets Total Return
| FEB | YTD | 1 YR | |
|---|---|---|---|
| Commodities | (4.7%) | (5.2%) | (4.7%) |
| REITs | (5.9%) | 3.5% | (12.2%) |
| Infrastructure | (3.4%) | 1.5% | 0.1% |
| Hedge Funds | |||
| Absolute Return | (0.2%) | (0.1%) | 1.7% |
| Overall HF Market | (0.5%) | 1.2% | (1.5%) |
| Managed Futures | 2.1% | 1.3% | 16.2% |
Economic Indicators
| FEB-23 | AUG-22 | FEB-22 | |
|---|---|---|---|
| Equity Volatility | 20.7 | 25.9 | 30.2 |
| Implied Inflation | 2.4% | 2.5% | 2.6% |
| Gold Spot $/OZ | $1827 | $1711 | $1909 |
| Oil ($/BBL) | $84 | $96 | $101 |
| U.S. Dollar Index | 121.6 | 123.5 | 116.0 |
Our Take
For the last several months, the “rock stars” of economic data points have been those that describe inflation, and this month was no different. Year-over-year trends still seem to suggest that inflation is turning over, but January’s reading (the most recent) indicates the path forward is unlikely to be a straightforward decline. After decelerating since last October, prices in January rose 0.5% after just a 0.1% increase in December. Understandably, the uptick jolted financial markets, which have begun to price in a higher probability that the Fed will keep raising interest rates.
Currently, derivatives markets are pricing in that the Fed’s key interest rate (Fed funds rate will be 5.4% by September (up from 4.6% now). Meanwhile, consumer expectations for long-term inflation (over the next five years or more) have been anchored in the 2.5%-3.0% range. This is far below the 6.4% inflation experienced in the past 12 months, and it indicates consumers are not likely to accelerate purchases in anticipation of rising prices, further fueling inflation.
Other key economic indicators point to a potential recession or at best a slowdown in growth as higher interest rates take their toll on key economic drivers, including the real estate market and S&P 500 earnings, which were down 4.8% for 4th quarter 2022, the 1st drop since 2020. The Conference Board’s Leading Indicators Index has fallen for 10 straight months, something that has never happened without a recession following soon thereafter.
On the positive side, the labor market continues to be the torch bearer of US economic resilience even if job cuts have risen in the last few months. Assuming the data leans negative and a recession is the offing, that is not necessarily a bad thing since recessions wash away excesses, create new opportunities for investors, and truth be told, usher in robust equity and bond market performance not long thereafter.
Aside from economic fundamentals, increased geopolitical risk, a topic we wrote extensively about it in our latest quarterly Commentary, remains top-of-mind. Essentially, the global economy has benefited from a peace dividend since the fall of the Berlin Wall in the form of a massive tailwind from cooperative trade, reprioritized military spending and globally integrated supply chains. In the past three years, we’ve seen a global pandemic, the war in Ukraine, and rising US-China tensions marking a shift toward regionalism and nationalism/populism, with great implications for economies and markets.
Looking Forward
“In the middle of difficulty lies opportunity” is a phrase ascribed to Albert Einstein. It is of relevance to investors today because we are in an uncomfortable environment where volatility is a constant companion instead of an occasional visitor. When fear and risk dominate, it is incumbent upon us as advisors to identify what is being overlooked by investors and use that to drive longer-term portfolio results. Currently, opportunities related to the restructuring of global supply chains and the building/renovation of infrastructure are among those we are exploring via the public and private markets.
Other positive considerations: Higher interest rates are a double-edged sword: they pose a risk to the economy but they also mean low-risk, short-term debt can offer a decent yield, which hasn’t happened for at least a decade. Equity valuations have become more attractive in the US and even more so in foreign markets. And US bonds and stocks have performed well historically in different types of inflationary environments, as long as inflation does not rise beyond 6% and stay there.
