After a terrible January for the markets, February continued the decline, with fears about inflation and Fed rate increases dominating the start of the month, only to be superseded by the Russian invasion of Ukraine. Although the Covid-19 news continued to improve, by the end of the month, markets had moved on from medical risks to economic and geopolitical fears. Looking forward, those are the risks that are likely to dominate, as Covid-19, while still with us, has left both the headlines and, apparently, the markets.
Market drops. The declines were widespread, extending across asset classes and around the world. U.S. markets were down between 3 percent and 4 percent, with the Nasdaq getting hit worst. International markets did slightly better, with losses from 1 percent to 3 percent. Even fixed income pulled back again, as interest rates rose midmonth, although the damage was limited as they ticked down again at month-end.
Despite the declines, overall market volatility remains within normal limits. We have, however, seen a technical breakdown, as all three U.S. indices closed the month below their 200-day moving averages for the first time since March 2020. International markets closed below that trend line for the second month in a row. Looking forward to March, this raises the risk of another weak month in the markets.
High inflation and rates. That higher risk is also supported by economic and geopolitical developments. As of February, inflation rose even further, with the headline number up by 7.5 percent year-on-year, reaching another 40-year high. Core inflation showed a similar gain, suggesting that pressure remained on the Fed to raise rates to contain it. Looking forward, however, we have already seen substantial increases in gas and energy prices as a result of the Ukraine war, which will likely push inflation even higher in the short term and is likely to spread as the effects widen. The Fed, already under fire for being behind the curve, has continued to signal that it will be tightening monetary policy this month. Expect both higher inflation and higher interest rates in March.
Economic momentum. While the risks from monetary policy, inflation, and geopolitics remain real, the underlying economy retains a substantial amount of momentum. The February jobs report showed a much larger-than-expected jobs gain, at 678,000, while the unemployment rate ticked down to a post-pandemic low. Consumer confidence remained at a relatively high level, and consumer spending remained strong. Business confidence and investment held up as well. Despite the fears, the economy looked to be continuing to improve.
The unknowns. Looking forward, though, the most relevant risks at the start of March—the effects of the Ukraine war, including especially high gas prices—had not yet shown up in the data from last month. While the March jobs report is also expected to be strong, that too will be backward-looking. March or possibly April will give us a much better take on what the impact of the war on the U.S. economy is likely to be over the next couple of months. At the moment, we simply don’t know.
Reasons for optimism. Given the momentum we have seen so far, there is still reason to be optimistic. Despite the real economic damage from Covid-19, for example, not only had the economy not weakened during the past several months of the Omicron wave, it had actually picked up momentum. Looking forward, while we will certainly see some short-term damage to both inflation and sentiment from the war, we still have enough economic cushion that we can reasonably expect the recovery to continue.
The Fed. Which leaves us with the Fed. High inflation and plans to raise rates remain a worry and, as noted, are likely to get worse. Looking forward, higher inflation rates are almost certain in March, and the fact that the employment report will also likely be quite strong means the Fed will very probably move forward with the signaled rate increase. This should actually reassure markets that the Fed is confident enough in the economy to raise rates despite the war, and it would be a good thing.
Beyond the rate increase, though, the real question for the March meeting will be how the Fed signals the next step. There were already signs the Fed was trying to tamp down expectations for rate increases. So, with the increased economic risks from the war, we might well see the Fed dial back a bit on its rate increase signaling during this month. A combination of a rate increase plus some signal that future increases might be less likely seems a reasonable expectation—which would also, not by accident, help to reassure markets.
Ukraine war. While we can make some reasonable guesses, March will still be an unusually uncertain month, as policymakers and investors try to process what the Ukraine war means. Between the impact on global food and energy supplies, the further constriction of global supply chains, and the real uncertainty about how wide the military confrontation will be, we simply don’t know what will happen—and that will continue to generate more market volatility.
At the same time, given the momentum of the U.S. economy and the relative isolation of that economy, prospects still remain reasonably favorable here, and that should cushion the market impact over the medium to longer term.
The Long View
Still, there is no doubt March is likely to be a difficult month. With the risks that are still out there, even the existing economic momentum is unlikely to be able to fully cushion the impact of world events. Expect more volatility. Even so, the longer-term picture remains better.
Keep calm and carry on.