February saw equity markets reverse much of their gains from the start of the year. And now it looks like the debate investors were having around the health of the January bounce is being resolved in favour of the Bears. In hindsight, that move seems to have been more of a reversal of the aggressive selloff in 2022 than the beginning of a broad-based rally.
Before we can shout the all-clear, we need comfort that these three objectives (listed in no particular order) are on track to be met:
- We need to see earnings growth.
- On the economic front, investors will need to be comfortable that inflation is peaking, which will allow central bankers to pause their rate hikes.
- We’ll need to see signs that a recession will be avoided or, at minimum, that there will be a soft landing.
The market optimism at the start of the year was that these conditions could be met. However, as February progressed, so did the realization that this optimism may have been premature.
It wasn't just equity markets that had become complacent. Bond markets also started to price in expectations of rate cuts in the second half of the year. However, these beliefs have been thrown into question of late, as stubbornly high inflation persists around the globe. As a result, bond yields, which had been trending lower, turned up across the curve. The U.S. 2-year bonds reached levels not seen since 2007, which has led to one of the most-inverted yield curves we’ve seen in years.
On the earnings front, the recently reported earnings for Q4 2022 came in roughly in line with expectations. But the fact we didn’t see as many misses seems more to do with reduced expectations than stronger operations. For the year, strategists continue to expect earnings to drift for the broader market. With negative earnings growth and an elevated valuation, it’s hard to see equity markets moving much higher in the short term.
Combined, these headwinds made it a difficult month to find hiding places for investors. Higher yields took a hit at higher multiple technology stocks and high-yielding defensive sectors and also led to a higher U.S. dollar. The higher dollar weighed on commodities, which had been performing well because of global growth beliefs following China’s reopening.
Coming into the year we had expected an increase in volatility, and so far, that’s what we’ve seen. Options trading activity has picked up with the higher volatility contributing to violent intra-day swings. One of the most consistent value-added strategies in this environment is option writing to harvest the volatility and generate income.
Entering March, there is a lot to look forward to but a lot to be concerned about.
On the economic front, we’ll get the chance to review more inflation and payroll data for positive signs, which will be factored into another Fed meeting later in the month. Previously, the meeting was expected to be an opportunity for the Fed to signal a pause, but now it’s looking more likely to be a continuation of their hawkish stance.
Then, near the end of the month, we’ll be gearing up for another round of earnings reports to monitor for the lagged effects of interest rate hikes on the health of corporations.
With this backdrop, it’s difficult to be either very bullish or very bearish. Any datapoint could change the narrative from one side to the other, and in a market that is increasingly swayed by program trading and options strategies, small moves can quickly become larger.
This is not a market to be complacent or passive; it must be monitored at all times. After experiencing the setback of 2022, many were looking for some relief this year. It may still happen, but it won’t be a straight line higher—there will be many bumps along the way.
Was February just one of those bumps in the journey or was it a wall? As Julius Caesar found out, one must “Beware the Ides of March” and be ready for more volatility.
— Greg Taylor is the Chief Investment Officer at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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