Economic and market perspective
After a record fifteen consecutive months of positive total returns, the S&P 500 declined 3.7% in February. This included an intra-month decline in excess of 10%, constituting the first equity market correction since a 13% decline at the end of 2015 and beginning of 2016. During the February correction, equity market volatility spiked to its highest level since mid-2015 and interest rate volatility rose to its highest level since the beginning of 2017. The correction was partially driven by higher inflation data, including wage data, and rising Treasury yields.
The impacts of the U.S. tax reform passed in December continue to be felt. Changes in withholding for personal income taxes began mid-February, which should generally increase disposable income. In addition to the positive impacts on consumer confidence, the repatriation of cash has also begun. As a significant portion of these assets are held in short maturity government and corporate fixed income, there has been selling pressure on these assets as cash is repatriated to the U.S.
The Bank of England (BOE) raised its GDP growth projections and U.K. wage growth data is improving, while inflation has been above target. During February, Mark Carney, Governor of the Bank of England, said that “in order to bring inflation back to target it is likely to be necessary to raise interest rates, to a limited degree, in a gradual process, but somewhat earlier and to a somewhat greater extent than we had thought in November.” The market has interpreted the statements as increased hawkishness from the BOE and an indication of two rate hikes this year, with one in May and the next in the November timeframe.
While U.S. inflation data has increased and U.K. inflation is above target, European inflation remains persistently below target. Inflation fell for the third month in a row, with a 1.2% reading in February, the weakest in over a year. Nonetheless, the European Purchasing Managers’ Index rose to 58.8 in January from 58.1 in December, the highest level in over a decade and fourth quarter GDP growth was 0.6% (2.4% annualized.) German 10 year bunds closed the month at 0.66%, 4 basis points lower than at the end of January, but 23 basis points above the start of the year.
Minutes from the Federal Open Market Committee’s January 30-31 meeting were released in February. Notably, the minutes stated that “strengthening in the near-term economic outlook increased the likelihood that a gradual upward trajectory of the federal funds rate would be appropriate.” The optimistic tone of the Fed members expressed in the minutes is widely assumed to have been strengthened since the end of January when the meeting was held, given the inflation and wage data released in the interim. The January meeting was the final one chaired by Janet Yellen, the March 20-21 meeting will be chaired by Jay Powell, whose term began on February 3. Markets are projecting a 100% likelihood of a hike in the Fed Funds rate at the upcoming meeting.
In his much anticipated first testimony to Congress as Fed Chairman, Jay Powell focused on balancing the desire for inflation to meet Fed targets on a sustained basis with preventing an overheating economy. He acknowledged that both the broad economic outlook had improved and inflation prospects had increased since the December meeting, highlighting fiscal policy as one source of the stronger economic outlook. In responding to a question, Chairman Powell left open the possibility that the Fed could raise rates more than the three times projected in the December minutes, which surprised markets.
Outlook and conclusions
In our view, the brief equity correction and the increase in U.S. ten year Treasury yields have been healthy for markets, even if producing short term discomfort. Long awaited wage growth and inflation have begun to appear, though there have been head fakes in this regard previously in the current cycle. As the markets sort out whether these represent isolated data points or emerging trends, an interesting interplay between equity and fixed income markets has been unfolding. Increasing rates prompted a sell-off in equities, which in turn prompted a flight to quality and decline in bond yields. After some back and forth, market participants were reminded of basic precepts of the game: equities can fall, even if they didn’t for over a year, and rates can rise, even if they barely nudged last year. After a volatile month for markets, but with strong economic fundamentals, fixed income valuations appear more attractive with both higher rates and modestly wider spreads. Broad market fixed income yields, now in excess of 3%, are at their highest level in almost eight years, offering a new opportunity for investors.