After a strong start to the year, helped by falling inflation and hopes of an imminent end to the global monetary tightening cycle, resilient economic data in February led to a move higher in bond yields and a decline in equity markets. The global aggregate bond index registered a 3.3% decline for the month, reversing much of the positive return recorded in January, while developed market equities were 2.4% lower.
With economic data indicating that a recession may not be imminent, investors reassessed their expectations for both the peak in interest rates and the subsequent pace of rate cuts, as the road back to target inflation could be longer than previously hoped.
While one might usually expect resilient economic data to support stocks, equity markets had clearly been looking forward to potential rate cuts and so were more disappointed at the prospect of less monetary easing in the near future than they were cheered by the prospect of a delayed recession.
The European Central Bank (ECB), Bank of England and Federal Reserve (the Fed) all announced rate hikes at the start of the month, in line with expectations. The broad message that emerged from the accompanying statements, with some nuances, was that despite the recent decline, inflation remains too high and the central banks’ job is not done yet.
Exhibit 1: Asset class and style returns
Source: Bloomberg Barclays, FTSE, MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. DM Equities: MSCI World; REITs: FTSE NAREIT Global Real Estate Investment Trusts; Cmdty: Bloomberg Commodity Index; Global Agg: Barclays Global Aggregate; Growth: MSCI World Growth; Value: MSCI World Value; Small cap: MSCI World Small Cap. All indices are total return in US dollars. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2023.
The strong economic news included labour market data, which remained resilient with unemployment rates that have moved below their pre-pandemic levels across many economies. The preliminary release of February purchasing managers’ index (PMI) business surveys also showed an improvement in the economic outlook across the major developed market economies. The headline composite survey rose above 50 into expansionary territory in the US and UK, while the eurozone remained in positive territory too. The employment components of the surveys were also above 50 in the US, UK and eurozone, confirming that the labour market remains tight, especially for the services sector.
European gas prices declined to EUR 50 per megawatt hour (down 40% year to date and 84% below last year’s peak) as gas storage levels remained very high for this time of year, despite the lack of Russian gas supply. The lower cost of energy is driving an improvement in consumer and business confidence and has helped support the outperformance of European stocks.
In China, the post-pandemic reopening is feeding a strong rebound in economic activity, with expected positive implications for both the domestic economy and its Asian and European trade partners.
US
At the beginning of February, the Fed voted unanimously to raise rates by 25 basis points (bps) to 4.75%, but the accompanying statement appeared dovish. Later in the month, however, Fed Chairman Jay Powell warned that the process of disinflation is expected to have a long way to go, and further rate hikes are likely needed, especially if macro data continue to come in stronger than expected.
Exhibit 2: World stock market returns
Source: FTSE, MSCI, Refinitiv Datastream, Standard & Poor’s, TOPIX, J.P. Morgan Asset Management. All indices are total return in local currency, except for MSCI Asia ex-Japan and MSCI EM, which are in US dollars. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2023.
Inflation in January confirmed this narrative. The consumer price index (CPI) rose at a year-on-year rate of 6.4% (headline) and 5.6% (core), which was lower than the previous month, but slightly higher than expectations. The CPI data acted as a reminder that the road to normal inflation could be bumpy. Shelter (housing costs) remained the major contributor to CPI.
The January labour market report was much stronger than expected, in terms of seasonally-adjusted job growth. Retail sales also surprised to the upside in January, posting an increase of 3.0% month-on-month.
UK
As expected, the Bank of England raised rates by 50bps at the beginning of February, moving the base rate to 4.0%. The tone of the statement was dovish though, with Bank of England governor Andrew Bailey declaring that inflation has turned a corner. Headline and core inflation fell to 10.1% and 5.8% respectively, but remained at high levels.
Despite signs of economic moderation, with GDP growth in December falling into negative territory (-0.5%), the unemployment rate was stable at 3.7%. Wage growth also came in at a very strong 6.7% year-on-year.
The significant improvement in the PMI business survey and an increase in consumer confidence added to February’s narrative of an improving global economic outlook, and hence a potentially higher path for rates. UK government bonds lost 3.5% in February.
The UK economy is, however, more exposed to rising rates than other economies given the shorter-term mortgage fixes compared with the US and most of Europe.
Exhibit 3: Fixed income sector returns
Source: Bloomberg Barclays, BofA/Merrill Lynch, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. Global IL: Barclays Global Inflation-Linked; Euro Gov.: Barclays Euro Aggregate Government; US Treas: Barclays US Aggregate Government - Treasury; Global IG: Barclays Global Aggregate - Corporates; US HY: BofA/Merrill Lynch US HY Constrained; Euro HY: BofA/Merrill Lynch Euro Non-Financial HY Constrained; EM Debt: J.P. Morgan EMBIG. All indices are total return in local currency, except for EM and global indices, which are in US dollars. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2023.
Europe
The ECB raised interest rates by 50bps to 2.5% in February, confirming the intention to “stay the course in increasing interest rates significantly, at a steady pace, and keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% target”. Despite the decline in headline inflation, driven by lower energy prices, ECB president Christine Lagarde is still concerned about core inflation and expressed explicitly the intention to increase rates by another 50bps in March.
Eurozone headline inflation fell in January to 8.5% but core inflation remained unchanged at 5.2%. Despite the hawkish tone, markets expect that interest rates could rise to 3.9% by the end of the year.
The fall in energy prices continued over the month, with positive effects on households and firms. Consumer confidence has rebounded from the extremely low level seen in late 2022 and is consistent with a possible pick-up in consumption over the coming months. Some energy-intensive manufacturing sectors are also restarting some production that was suspended at the peak of the energy crisis.
With risks of a deep recession decreasing significantly, Europe has been among the best performing equity markets, with MSCI Europe ex-UK up 9.3% year to date and European banks having rallied by over 40% since the lows of last October.
Exhibit 4: Fixed income government bond returns
Source: Bloomberg Barclays, Refinitiv Datatsream, J.P. Morgan Asset Management. All indices are Bloomberg Barclays benchmark government indices. All indices are total return in local currency, except for global, which is in US dollars. Past performance is not a reliable indicator of current and future results. Data as of 28 February 2023.
The European commission announced the “Green Deal Industrial Plan”, a revamp of the European Union Green Deal, which is focused on increasing the manufacturing capacity for green technologies and products. A ban on the sale of combustion engine cars by 2035 was also agreed.
These initiatives confirm Europe’s commitment to accelerating the energy transition. A substantial number of climate-related investments could be financed through the issuance of green bonds that offer lower financing costs, or a “greenium”, thanks to the strong demand for this type of instrument. More details on this topic can be found in our recent On the Minds of Investors article, “Green bonds: Is doing good compatible with doing well in fixed income?”
China
The post lockdown re-opening of China could lead to a rapid consumption-driven recovery in the Chinese economy. The huge amount of excess savings accumulated during lockdown are expected to fuel consumption. The economic recovery is mainly being driven by the services sector, with the Caixin January services PMI showing a sizable rebound to 52.9 (from 48).
Chinese stocks fell 9.9% over the month. Escalating geopolitical tensions drove some profit taking after having rallied 35.5% from their October lows. However, they remain down 47.5% from their 2021 peaks and could benefit from a stronger-than-expected economic recovery. More details on this topic can be found in our recent On the Minds of Investors article, “Marking the bottom of the Chinese economic cycle”.
Exhibit 5: Index returns for February 2023
Source: Bloomberg Barclays, MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results.
Data as of 28 February 2023.
Conclusion
An improvement in the near-term global economic outlook in February caused markets to price in expectations that rates would need to remain higher for longer in order to bring inflation back towards target. Bonds struggled as a result, while receding hopes of a rate-cut-induced rally weighed on equity markets.
We could see some more volatility due to the ongoing uncertainty about the trajectory of inflation and interest rates. Nevertheless, the current lower level of equity valuations compared to the beginning of 2022 means that markets might be less vulnerable to risks, including a recession, earning downgrades or higher interest rates. The decline in gas prices and reopening of China are also two fundamental improvements since October, which probably justify stocks being higher than they were then, even if rates are not cut as soon as markets had been expecting in January.
Our recent publication, “Making good investment decisions in times of volatility” examines reasons to stay invested and avoid letting the gloomy short-term market news dominate long-term financial planning.
Furthermore, markets tend to be forward looking, so if inflation does continue to fall it could drive central banks to end their monetary tightening and cut rates, providing relief to bonds and possibly stocks too.
Diversified and balanced strategies can help to build stronger portfolios, especially after fixed income markets have regained their traditional characteristics of offering income and being a good potential hedge against recession risks. More details on why we think bonds are back as a useful tool for investors can be found in our recent On the Minds of Investors article, “Fixed Income opportunities for 2023 portfolios”.
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