After a strong start to 2023, markets gave up January's gains in February. The culprit was improving economic data, which in theory should be good for stocks. However, its ability to fan the flames of inflation, which remains high, has left investors with a lingering belief that the US Federal Reserve is likely to keep rates higher for longer than expected.

Regions

In the US, equities found the inflationary backdrop challenging with the S&P 500 slipping by -0.97%. Inflation unexpectedly rose in February, increasing the likelihood of further rate hikes instead of a slowdown, as was previously anticipated when CPI inflation data appeared to cool in December. This was further supported by the stronger-than-expected ISM Services PMI data in January and the February 3rd US Jobs Report, which showed the country's unemployment rate falling to a 53-year low. (The Purchasing Managers Index or PMI is a monthly survey of the manufacturing industry and is used as an indicator for outlook)¹. CPI inflation also seemed to regain momentum. US data also indicated that both US consumers and businesses were yet to be deterred from spending following rate rises.

In February, Eurozone shares outperformed most other regions, as they did in January. The Euro STOXX rose by 1.14%, driven by improving business sentiment and decreasing inflation. Additionally, growth reported in Q4 raised hopes that the eurozone may avoid a recession. A mild winter helped prevent an energy recession, and China lifting Covid restrictions supported Europe's biggest economy, Germany, and its heavily reliant industrial sector.

UK shares posted the biggest regional gains, of those measured at 1.34% in February, buoyed by signs that the economy is performing better than expected. During the month, the UK services sector returned to growth, and government borrowing fell unexpectedly in January. However, weakness in the commodities market during February weighed on the UK indices, where energy and materials make up approximately 20% of the index.

In early February, the Japanese stock market experienced some good gains. However, after the announcement that Kazuo Ueda might become the next Bank of Japan governor and be less dovish than the current Governor, Haruhiko Kuroda, the Nikkei 225 slipped and closed the month down -2.50%. At the end of the month, Ueda addressed these concerns by stressing the need to maintain support for the country's economy with ultra-low interest rates.

Chinese shares have experienced strong gains since Beijing loosened its Covid-19 restrictions. However, the rally faltered in February as investors searched for a catalyst to sustain the run. By the end of the month, the MSCI China H index was down -5.77%.

Emerging markets underperformed developed counterparts, falling -4.54%, as the possibility of rates staying higher for longer, supporting a stronger US Dollar, weighed on investor sentiment.

Assets

Global government bond yields rose in February due to stronger-than-expected economic data, which fuelled concerns that the US Federal Reserve and other central banks would follow through on their intentions to raise rates in order to cool inflation. The losses in February wiped out the gains made in January, which were made due to expectations that central banks were close to pivoting on hiking rates. The two-year US Treasury yield is 4.88%, while the UK Gilt yield for the same term is 3.64%². Two-year rates are closely tied to short-term interest rates, which are now close to 4% in the UK and around 4.5% in the US, their highest level since just before the financial crisis³. They are also becoming a less risky haven for investors seeking income from their assets⁴.

Sticky inflation supporting a higher US Dollar proved a headwind for commodities, seeing the Bloomberg Commodity index fall over the month, falling -3.49%. Meanwhile, gold slipped -3.11%. The same factors continue to weigh down on real estate with the MSCI ACWI/REITS index falling -4.54% through February.

While all asset classes posted losses in February global equities was the best-performing asset class, posting a loss of -0.88%, based on data from the MSCI World Index.

Considerations for long-term investors

Investors are currently caught between two opposing forces: bad news such as slower growth, which could potentially boost asset prices, and good news such as strong economic expansion, which could lead to markets falling due to higher rate hikes in the future. This dichotomy is driving the direction of markets in the short term and is well illustrated by the contrasting performance of markets in January and February.

Such a stark and binary outcome makes conditions for investors extremely difficult over the short term. Investors should remain focused on their long-term goals and avoid making knee-jerk reactions based on short-term market movements. A well-diversified portfolio that includes a mix of stocks, bonds, and other asset classes can help investors weather the ups and downs of the market and achieve their financial objectives over time.

Given the volatility of markets, pound-cost averaging could continue to be a good strategy for long-term investors. This approach helps to remove the need to try and time the market and smoothes out returns into the future. Investors might also consider investing in Value or Recovery funds. This style of investing involves fund managers trying to eliminate as much market risk as possible by owning companies that have a suitable margin of safety below the intrinsic value of the businesses they invest in. In theory, this approach lowers the risk of losses while providing potential gains over the long term.

The broad repricing of bonds and higher starting yields may once again present a longer-term opportunity worth considering. With yields upwards of 4% on investment-grade bonds, they are interesting once more for income seekers. Additionally, they can act as a cushion against the impact of market volatility.

Sources: FE Analytics (monthly performance figures for funds and market 31/01/2023 to 28/02/2023). Qualitative commentary from TILLIT meetings with fund managers.

(1) Source: https://uk.investing.com/econo...
(2) Source:https://www.cnbc.com/bonds/
(3) Source: https://www.bankofengland.co.u...
(4) Source: https://www.federalreserve.gov...