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Renewed inflation concerns have sparked worries of extended rate hikes

After a strong rally to kick off 2023, renewed inflation concerns have sparked worries of extended rate hikes, weighing on equity-market performance. U.S. equities were lower this week in moderate volume, with the S&P 500 having the worst weekly performance since September. The Nasdaq posted the worst weekly performance since November, while the small-cap Russell 2000 staged the worst performance since January 2022. Markets ended noticeably lower for the week, as the DJIA dropped -4.4%, the S&P 500 declined -4.6%, and the Nasdaq Composite tumbled -4.7%. All sectors were lower, with banks declining the most. Financials led the declines within the S&P 500 and contributed to the pronounced weakness in value stocks. Concerns grew throughout the week about the financial stability of SVB Financial, or Silicon Valley Bank, as customer pulled deposits after the technology-oriented regional bank was forced to sell and realize losses in securities held on its balance sheet to meet capital requirements—marking the second-biggest bank failure in U.S. history, according to The Wall Street Journal. Trading in SVB stock was halted Friday morning, and the Federal Deposit Insurance Corporation (FDIC) then placed the bank into receivership to protect depositors. Stocks in other regional banks fell in response, although only moderately, suggesting that investors concluded that SVB’s risk exposure was exceptional. Shares of the major “money center” banks (Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo) held up better, in part because stricter banking regulations required them to previously mark down the value of some securities.

The regulatory shutdown of a California-based commercial bank that focuses on lending to technology companies triggered a surge in volatility that hit bank stocks and extended to the broader market as well, especially small caps. The Cboe Volatility Index, which measures investors’ expectations of short-term U.S. stock market volatility, surged 29% over the course of Thursday and Friday.

Treasuries rallied gaining most of their weekly strength on Friday, with the 10-year yield increasing 1 basis point to 3.96%. Investment grade and high yield corporates outperformed again, returning 0.42% and 0.78% respectively last week, and beating similar-duration Treasuries by 24 and 80 bps.

European stock indexes moved parallel to their U.S. counterparts in negative territory for the week amid worries about stress in the banking system and the potential effects of a prolonged period of elevated interest rates, nevertheless they outperformed the US indices by a wide margin to extend their year-to-date out performance. Specifically, the pan-European STOXX Europe 600 Index ended 2.26% lower in local currency terms. Major stock indexes also fell. Germany’s DAX Index weakened 0.97%, France’s CAC 40 Index declined 1.73%, and Italy’s FTSE MIB Index dropped 1.95%. The UK’s FTSE 100 Index lost 2.50%. Eurozone economic growth in the fourth quarter was revised down to 0% from an initial estimate of 0.1%. Consumer demand weakened in January. Retail sales grew 0.3% sequentially—much less than expected—and dropped 2.3% from year-ago levels.

February’s jobs report brought some welcome news, as jobs and wages moderated. This shows an encouraging slowdown in jobs even though the pace of job growth remains too strong for the Federal Reserve, further raise rates are expected. While some slowdown in February’s labor market release reduces the chances the Fed was anticipated to hike rates by 50 basis points later this month before the SVB crisis. Still next week’s Consumer Price Index release will be important in determining whether the Fed hikes rates by 25 or 50 bps later this month. Nonfarm payrolls for February rose by a stronger-than-expected 311,000 and were revised lower in the prior two months. February’s data reflects that job growth remains stronger than the Fed wants. Also, the strength in the retail and leisure sales categories continues to show the strength of the services sector. The unemployment rate for February rose to 3.6% from 3.4% in January, as a significant 416,000 increase in the labor force easily outpaced a 177,000 rise in the household measure of employment. The labor force participation rate increased to 62.5%, the highest level since March 2020. Fed Chairman Jerome Powell gave a hawkish testimony before the Senate Banking Committee as part of the Semiannual Monetary Policy Report to Congress on Tuesday.

Chinese equities retreated as signs of weakening demand and a lower-than-expected 2023 growth target unveiled by Beijing tempered concerns about the country’s outlook. In Hong Kong, the benchmark Hang Seng Index plummeted roughly 6%, its biggest weekly loss in over four months, according to Reuters. Beijing set an economic growth target of around 5% this year at the National People Congress (NPC).

Equity and bond markets will be heavily affected by elevated volatility until there’s a meaningful and consistent decrease in inflation, and the duration of higher rates is more certain. Investors should become more comfortable with a “data-dependent” Fed that’s now focused on the cumulative effects of rate hikes before introducing more funds into the equities’ market. We remain defensive in our positioning, and we’d look for opportunities to upgrade portfolios during market weakness. Within equities, we continue to favor U.S. Large Cap exposure, since China’s evolving COVID policies continue to weigh on manufacturing and growth. We’ve recently become more constructive on Developed International equities (mainly European), as the energy recession wasn’t as severe as anticipated. In the United States, large cap equities provide an attractive blend of quality, yield and growth at a reasonable value, albeit at higher valuations, as earnings expectations continue to deteriorate. For fixed income, we recommend we slowly move to longer-dated bonds. We remain defensive in our credit positioning, with at benchmark duration, and higher in credit quality. We expect credit spreads will leak wider to account for slowing growth and recession risks.

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