February witnessed a shift in the narrative surrounding financial markets. Stronger-than-expected economic data releases raised concerns that central banks might raise interest rates more aggressively than previously anticipated. As a result, equity markets experienced a pullback after a strong start to 2023, while bond markets erased the gains from January and ended the month around the same levels as the beginning of the year.
The month began with key central bank decisions from the Federal Reserve (Fed), Bank of England (BoE), and European Central Bank (ECB). The Fed raised interest rates by 25 basis points, bringing the Fed funds rate to 4.5%. The BoE increased its base rate by 50 basis points for the second consecutive time, reaching 4.0%. The ECB, still catching up, implemented another 50 basis point hike, setting the main refinancing rate at 3.0%. These moves were generally in line with market expectations, signalling that monetary policy was approaching the end of the tightening cycle.
However, the optimistic view was challenged by a robust US jobs report released just two days after the Fed's announcement. The report revealed the addition of 517,000 jobs in January, the highest reading in nearly a year and almost double the previous four releases. The unemployment rate also decreased to 3.4%, raising concerns among investors that the markets had been overly optimistic about the imminent end to rate increases.
Derivatives markets now indicate that the terminal rate, the level at which the Fed will stop increasing interest rates, is around 5.4% with no rate cuts expected in 2023. This represents a significant change from the beginning of the year when the same markets predicted a peak below 5% followed by two rate cuts before the year's end.
In terms of inflation, the US consumer price index rose for the first time in four months. The personal consumption expenditures (PCE) price index, the Fed's preferred inflation gauge, showed a 0.6% increase in January and a 4.7% rise annually, both higher than expected. Retail sales also surpassed expectations. These factors raised concerns that price pressures were persisting longer than anticipated, indicating a slower pace of disinflation, particularly in goods' prices.
While the peak in inflation is likely behind us, and a return to the highest levels of 2022 is not expected, evidence suggests that price pressures are proving stickier than anticipated. Reaching central bank targets of around 2% seems increasingly wishful.
The MSCI All Country World Index ended February with a decline of just under 3%, but UK-based investors were shielded from the majority of the loss due to a 2.3% depreciation in the GBP/USD rate. UK stocks outperformed, rising approximately 2.7%, driven by record profits for oil majors BP and Shell. European indices also provided positive returns, gaining nearly 2%.
US stocks continued to underperform since bottoming out in October, with a 2.6% loss in February. However, they remained up by around 3% for the year. The consumer discretionary and industrial sectors continued to perform well, partly driven by the reopening of China.
Interestingly, technology shares exhibited relative strength despite their typical sensitivity to rising interest rates. While they experienced a 1% decline in February, they were still up nearly 9% year-to-date. This inconsistency may be attributed to money flowing back into riskier parts of the market as sentiment improved, indicating that some money managers may still be following patterns that worked well before 2022.
Bond markets returned to levels seen at the beginning of the year, completing a round trip after a strong January. Gilt markets ended February with a decline of around 3%, while credit outperformed with a 2% decline. Despite ongoing central bank tightening, financial conditions eased slightly since the start of the year, which can be partly attributed to the rise in equity markets.
In China, leading indicators pointed to heightened optimism due to the reopening of the economy, with purchasing managers' indices for February showing expansion in both manufacturing and services sectors. This provided a significant tailwind to the global economy, although its impact on inflation remained less clear. Chinese equities bounced strongly in recent months, and favourable valuations suggest the potential for further upside.
In conclusion, recent developments have introduced some uncertainty into the outlook, although the overall view remains constructive. Near-term risks have increased, leading to a revision of tactical asset allocation by trimming exposure to UK and North American equities while increasing fixed income holdings and raising cash slightly. The macro picture has numerous moving parts, and short-term uncertainty is elevated. While central banks are expected to avoid excessive tightening that could hamper economic activity, the persistence of current dynamics increases the risk of a central bank error. Risk appetite is described as fairly neutral, and the attractive nominal returns on cash and bonds have prompted a reduction in risk exposure.