Mullaney on the Markets | A Resilient Economy Alters Interest Rate Expectations

By Michael Mullaney | Director of Global Markets Research
Published March 2023

For the Economy, a “No-Landing” Scenario Takes Hold

During February continued signs of strength in the U.S. labor market, a surge in the service side of the economy and an above consensus print for the Fed’s favored inflation measure led investors to shift their conviction on what lies ahead for domestic economic growth, from recession to “soft-landing” to “no-landing” that forced a recalibration of the future path of interest rate moves by the Federal Reserve. Both stocks and bonds suffered, with the S&P 500 Index posting a loss of -2.45% and the Bloomberg U.S. Aggregate Bond Index dropping by -2.59% during the month.

The “risk on” mentality displayed by investors during January and the corresponding spurt of investment returns was enough to offset February’s losses, with the S&P 500 Index maintaining a gain of +3.69% and the Bloomberg U.S. Aggregate Bond Index advancing by +0.41% on a year-to-date basis.

A Handful of Stocks Dominate Performance

Ten out of the eleven sectors that comprise the S&P 500 Index gave ground during the month with Energy pulling up the rear with a loss of -7.26% as oil fell by -2.31% and natural gas by -6.02%, as temperatures on a global basis remained above average and overall supply was largely unaffected by Russian sanctions. Two bond proxy sectors suffered during the month, Real Estate at -5.99% and Utilities at -5.00%, as interest rates rose by an average of 0.42% on Treasury securities ranging from 3-months to 30-years in maturity.

The lone winner for the month was the Technology sector at +0.45%, an unusual result given the jump in rates and the sector’s typical sensitivity (duration) to interest rate changes. With over two thirds of the stocks in the sector posting losses during the month, almost all of the return for the sector can be explained by the performance of two stocks, NVIDIA which gained +18.83% for the month on the expectation of increased demand for its chips for artificial intelligence (AI) applications, and Apple (+2.32%) which represents nearly a quarter of the sectors market capitalization.

Seven sectors maintained gains on a year-to-date basis, with three standouts:  Consumer Discretionary (+12.54%), Technology (+9.82%) and Communication Services (+9.17%). Further analysis found that the “FAANG” stocks (Facebook, Apple, Amazon, Netflix, Google) posted an average return of +14.04% and contributed 41% of the S&P 500 Index’s overall return. When the “MNT” stocks (Microsoft, NVIDIA, Tesla) from those sectors were added to the mix (newly coined moniker: “The Mega-8”), their collective average return of +43.38% contributed an additional 39% of the S&P 500 Index’s overall return. Simple math shows that 80% of the S&P 500 Index return year to date came from just eight stocks.

At the opposite end of the spectrum year to date came a couple of sectors usually considered to be defensive by nature (Health Care: -6.39%, Consumer Staples: -3.27%), a bond proxy (Utilities: -7.75%) and Energy (-4.51%).

Varied Performance of Risk Characteristics

Measures of risk were mixed during February. High-quality stocks (those rated “B+” or higher by Standard & Poor’s) outperformed low-quality stocks (“B” or lower) by +1.16%, but small-cap stocks (Russell 2000® Index), which are usually considered to carry higher risk, beat large-cap stocks (Russell 1000® Index) by +0.69%. Also, stocks in the highest beta quintile of the S&P 500 Index beat the lowest beta quintile by over +6.15%, though much of that outperformance can once again be traced to the return of the FAANG and MNT cohorts of the market, which have both high-beta and high-quality characteristics.

Year-to-date risk was one dimensional, that being “risk-on,” as low-quality stocks beat high-quality stocks by +6.57%, high-beta beat low-beta by +24.26% and small caps beat large caps by +3.72% on the categories defined above.

Despite Higher Interest Rates, Growth Stocks Gain

In terms of style, growth outperformed value by an average of +1.93% across the Russell 1000®, Russell Midcap® and Russell 2000® Indices market capitalization ranges during February. This was unusual given that growth stocks are normally more sensitive to changes in interest rates (longer durations) than value stocks and usually follow the return pattern of long-dated Treasury bonds, which fell by over -4% during the month. Once again, the concentration of returns in a handful of stocks distorted typical return patterns. For example, the five largest holdings in the Russell 1000® Value Index represent some 11.44% of that benchmark and produced an average return of -3.30% during the month, but the five largest holdings in the Russell 1000® Growth Index represent 25.66% of that benchmark and an average return of +1.09%. Apple on a standalone basis is 33% larger than the Russell 1000®  Growth Index Financials, Real Estate, Energy and Materials sectors…. COMBINED!

Year to date, growth stocks have outperformed value stocks by an average of +3.45% across the Russell capitalization ranges as described above. This is more understandable given that the 30-year Treasury Bond gained +1.38% over the period.

Mixed Results for Non-U.S. Markets

Returns for developed market international stocks outpaced the S&P 500 Index in February.  The MSCI EAFE Index gained +0.63% in local currency terms and was rewarded for both revenues and earnings of the companies in that benchmark growing at a faster pace than the S&P 500  Index during the recently concluded fourth quarter earnings season. In U.S. dollar terms the return for MSCI EAFE Index was lower at -2.08%, as the DXY Index, a measure of dollar appreciation/depreciation versus a basket of six foreign currencies (the Euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona) rose by +2.72% over the course of the month. Year to date, the MSCI EAFE Index maintains a comfortable lead over the S&P 500 Index in both local currency terms (+6.98%) and U.S. dollar terms (+5.87%) helped by strong fundamentals and lower valuations.

Returns for emerging market stocks were lower than those of developed markets and the S&P 500 Index as the MSCI EM Index returned -4.65% in local currencies and -6.48% is U.S. dollar terms during February. The MSCI EM Currency Index fell by -2.24% during the month on the expectations of more aggressive Fed rate moves to be forthcoming. The MSCI China Index was particularly hard hit, posting a loss of -10.37% in U.S. dollar terms on anticipated repercussions from “balloon-gate” and the passing of the Lunar New Year holiday.

Year to date the underlying story is similar, with the MSCI EM Index gaining +1.60% in local currencies and +0.92% in dollar terms, showing once again that a strong dollar is usually detrimental to emerging market relative performance.

Economic Strength and Stubborn Inflation Raise Interest Rate Expectations

There were numerous signs of labor market strength during February with job openings exceeding expectations by 712,000 (about 7% higher than consensus), unemployment insurance jobless claims that averaged 189,000 per week versus an expected 198,000, Nonfarm Payrolls (jobs) increasing by 517,000 versus the 189,000 expected and the Unemployment Rate falling to 3.4% from 3.5% a month earlier and below the 3.6% level forecasted.

During the month The Institute of Supply Management (ISM) reported a stellar reading for the service side of the U.S. economy at 55.2 versus the prior months 49.2, the biggest gain since June 2020 and well above the 50 level, the demarcation line between expansion and contraction. Services make up about 75% of U.S. gross domestic product.

Inflation ran hot during January (reported in February) as the Personal Consumption Expenditure Price Index (PCE) increased by 5.4% year-over-year (Y-O-Y) on a headline basis versus the consensus expectation of a 5.0% gain. Core PCE, items less food and energy, increased by 4.7% Y-O-Y versus a forecast of 4.3%.

Core Services PCE less Housing, Fed Chair Powell’s so-called “core-core PCE” or “super-core PCE” rose month-over-month by 0.58%, the highest print since November 2021 and the fifth highest print in the last 30 years.

These results led investors to reassess what level of interest rates will be required to slow the economy, cool the hot labor market and reduce inflation. At the start of the month a hike of 20-basis points (an 80% probability of a 25-basis point hike) in the Fed Funds rate was priced for the March FOMC meeting and 11-basis points for the May meeting (a 44% chance of a 25-basis point move) with a terminal Fed Funds rate of 4.91% priced as of June before rate cuts were projected to begin. By the end of the month, a hike of 30-basis points in March was priced in (indicating a 20% chance of a 50-basis point hike) and a 26-basis point hike for the May meeting. Two potential rate hikes were added, 18-basis points in June (a 72% probability of a 25-basis point hike) and a 30% chance of an additional hike in July. The expected terminal Fed Funds rate increased to 5.18% and is now projected to hold that level through the end of the year.

Lower Inflation on the Horizon – Will It Last?

In reality, the “no-landing” scenario is really a “delayed-landing” as the Fed will keep ratcheting up interest rates until inflation breaks. Base effects will soon help, at least on the surface, as inflation a year ago was running at 40-year highs making today’s comparisons easier.

But base effects can be misleading, for example, if gasoline prices were to rise from today’s $3.91 per gallon to $4.10 by June that would be the tenth highest price for gas recorded over the last 20-years, but a 24% reduction from last year. By the end of the year the positives from base effects will begin to wane.

Higher rates due to elevated inflation, heightened geo-political risk and lower margin/earnings expectations do not seem all that conducive to a rip-roaring stock market.


Terms and Definitions:

S&P 500 Index:  The S&P 500 Index is a registered trademark of the McGraw-Hill Companies, Inc. and is an unmanaged Index of the common stocks of 500 widely held U.S. companies.

FAANG+:  FAANG is an acronym referring to the stocks of the five most popular and best-performing American technology companies: Meta (formerly known as Facebook), Amazon, Apple, NVIDIA, and Alphabet (formerly known as Google).

MSCI EM (Emerging Markets) Index:  Captures large and mid cap representation across emerging markets countries covering approximately 85% of the free float-adjusted market capitalization in each country.

Russell 1000® Growth Index:  Measures the performance of the largecap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years).

Russell 1000® Value Index:  The Russell 1000® Value Index contains stocks included in the Russell 1000® Index displaying low price-to-book ratios and low forecasted growth values. 

MSCI EAFE (Europe, Australasia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

MSCI EM (Emerging Markets) Index:  Captures large and mid cap representation across emerging markets countries covering approximately 85% of the free float-adjusted market capitalization in each country.

The Bloomberg US Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds, and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, Mortgage-backed bonds, Corporate bonds, and a number of foreign bonds traded in U.S.

DXY is the symbol for the US dollar index, which tracks the price of the US dollar against six foreign currencies, aiming to give an indication of the value of USD in global markets.

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