February was a good month for stocks, with most markets up in the low- to mid-single digits on positive economic and earnings news. The riskiest indices, the Nasdaq and emerging markets, performed especially well as investors stayed risk-on. Fixed income, on the other hand, generally declined as interest rates rose significantly during the month on fading hopes for Fed rate cuts. These results reflected the broader economy in different ways. But, where growth continues, so does inflation.
The markets and the Fed. Last month’s mixed markets were a battle between rates. They rose sharply before pulling back at month-end but still closed significantly higher. Continued economic growth and the conviction that rate cuts from the Fed weren’t coming any time soon drove the increase, pushing fixed income markets down. And it wasn't just the Fed, as the economic news suggested that inflation may not keep dropping.
The economy. Fourth-quarter economic growth for 2023 came in stronger than expected, and projections show that this will be the case for this quarter. Job growth was not only solid last month but accelerated, and wage growth and spending increased as well. Last month's data showed a resilient economy that will likely keep inflation reasonably hot—and keep rates higher for longer.
Earnings growth. For stock markets, even though higher rates usually mean lower stock prices, that outcome was overruled by expected strong economic growth, which could continue to support earnings growth. Last quarter's corporate earnings came in well above expectations, which is the case for this quarter as well. While interest rates and valuations will be a challenge, the strong economy and earnings growth will potentially more than offset that. This means that we still have a reasonable prospect of growth.
Political and international risks. While overall conditions are positive, risks remain. There is the Fed and interest rates. We also have the ongoing war in the Middle East, which is showing signs of expanding and affecting trade routes and supply lines. This could hurt inflation and growth. Further, domestic politics remain a concern as the election gets closer. But with the fundamentals reasonably healthy and the macro picture stabilizing, many economic fears that pulled markets back last year may be subsiding.
Economic growth and inflation. As we move into the year, the key issues remain how fast the economy grows and what that could mean for inflation. Market expectations on rates have changed rapidly. Now, those expectations are more aligned with reality, so the effects of the Fed are likely to be less negative going forward. That said, all of this is data-dependent, and we will need to keep an eye out for changes.
Overall, conditions remain solid, but volatility is quite possible. We saw some turbulence in February, and we aren’t out of the woods on inflation yet. While the trends remain positive, risks could increase over the next couple of months. Still, given the strong economic fundamentals, these risks are something to watch for but not worry about too much.