By: Stash Graham
Asset prices pulled back broadly as investors started pricing in “higher for longer” when considering interest rates. The best-performing asset class was high-yield bonds which lost -1.5%. Their fixed-income sibling, investment grade bonds, were down -3.2%. Both U.S. Treasuries and the S&P 500 fell -2.5%. The Dow Jones Industrial Average gave up -3.9%. Commodities decreased by -5% as a broader economic slowdown supplemented interest rate concerns. Only one other time in the last 40 years was there a month with the worst performance from the best-performing asset class (High Yield Bonds, -1.5%). On a relative basis, we are glad that our accounts did not have to participate in such downside.
The weakness in February was consistent throughout the month. Weak corporate earnings, which had contracted for the first time since the COVID recession, and elevated inflation figures were a considerable headwind for asset prices. A breather makes sense considering the rally that asset prices had in January. As we mentioned in our skepticism of the rally in January, the factors that were leading the rally were not the type that you would want leading a rally if you believed there was a market bottom that had already occurred. Leverage and speculative (unprofitable business models) were the leaders, while quality, cash flow-producing businesses lagged. You want a consistent stream of bankruptcy restructuring of highly levered, poor firms at a market bottom while quality companies lead a rally. We are noticing a slight uptick in the number of bankruptcy restructurings but not at levels worth emphasizing.
The Federal Open Market Committee released the minutes from their February 1st meeting, which helped provide a slightly lagging look into the mind of the right arm of the Federal Reserve. Fed staff revised their near-term inflation outlook, marking down their view of the 2023 headline and core PCE (Personal Consumption Expenditure) inflation to 2.8% and 3.2%, respectively. In comparison, the December SEP projected core PCE to moderate to 3.5% this year. Notably, “a few” participants no longer see risks to the baseline inflation forecast as skewed to the upside, and the minutes revealed materially more concerns about downside risks to growth. That’s a stark contrast with the current outlook, with market participants instead talking about a reacceleration in economic activity. In addition, the word “recession” was mentioned four times in the minutes, compared to three times at the December 2022 meeting and only once in November. “Some” FOMC participants noted that the recession probability in 2023 remains elevated. Federal Reserve staff see a recession this year as the baseline. However, since this meeting, we recently received a PCE inflation report above expectations. As such, the futures market has now priced in that we will see 25 basis point rate hikes at the March, May, and June FOMC meetings. Equity prices did not take kindly to this development and put at-risk assets, like stocks, under further pressure.
The situation in Eastern Europe worsened as Russia formally withdrew from the START Treaty. A few days later, President Biden and Treasury Secretary Janet Yellen, on separate trips, visited Ukraine. Lately, you have seen less coverage of the Russian invasion of Ukraine than warranted. As we just discussed, inflation has been coming down in recent quarters, and the Fed is expecting lower inflation; however, over the next couple of years, material inflation threats could generate inflationary spikes similar to what we saw last Summer. It is tough to see a situation where Russia and the resources they provide come back to the global market promptly. The Ukraine invasion will either end up where Russia wins and receives harsher sanctions than they currently have for a more extended period, or they will lose, and there will be a change in Russian leadership with a more extreme ideology. Regardless of the final result, the trifecta of Russia, Belarus, and Ukraine are the world leaders in providing: Natural Gas, Uranium, Neon, Processed Nickel, Semi-finished Iron, Wheat, Fertilizer, and Potash. Energy product prices are where the mind first goes, but there are other major inflation-related considerations. For example, Russian fertilizer exports are down 20-40% over the last year (depending on your nutrient mix). Large-scale farmers were able to avoid the shortage during the previous summer as there was an adequate fertilizer reserve in place. Over the last farming season, this reserve understandably was drawn down. As a result, even without further escalation, there are elevated risks of spikes in global food inflation. As we have seen in the trailing quarters, the U.S. can avoid the worst inflationary pressures, but higher inflation will negatively impact the American consumer. These developments could further impact the Federal Reserve and its monetary policy decisions, directly affecting financial asset prices. We will continue to monitor all closely related events to the conflict closely.
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