The Month At-A-Glance
● S&P 500 reached a new all-time high mid-February before surrendering those gains
● Softer economic data and elevated inflation readings sparked stagflationary concerns
● Uncertainty around tariffs, immigration, federal layoffs, and the Ukraine-Russia War dampened investor sentiment
● The yield curve inverted again as the 10-year Treasury yield fell below the three-month rate
Market Recap
February marked a shift in the “U.S. exceptionalism” narrative. The S&P 500 declined 1.3%, compared to gains of 1.9% for MSCI EAFE and 0.5% for MSCI Emerging Markets. This 3%-plus outperformance by developed international stocks represented their largest monthly advantage over U.S. stocks since late 2022.
Within U.S. markets, large-cap value stocks outperformed growth stocks, with traditionally defensive sectors (utilities, health care, consumer staples) demonstrating relative resilience. Cyclically sensitive sectors, including consumer discretionary, energy, financials, industrials, and technology, led the markets lower. Small-cap stocks underperformed significantly, with the Russell 2000 Index falling 5.4%.
The rotation away from mega-cap technology and growth stocks continued. The Bloomberg Magnificent 7 Index has remained largely unchanged over the past several months, with some components entering bear market territory (>10% loss) this year. Two key factors appear to be driving this shift: the emergence of China’s DeepSeek large language model, which has tempered enthusiasm for U.S. tech dominance, and elevated valuations amid growing economic concerns.
Fixed-Income Performance
Fixed-income markets generated positive returns across almost all segments in February, driven by declining yields as economic uncertainty and weakening investor sentiment prevailed. Treasury yields fell across the curve, with the 2-year yield decreasing 23 basis points to just below 4% and the 10-year yield falling 34 basis points to 4.22%.
This yield compression occurred despite January’s Consumer Price Index (CPI) rising 0.5%, exceeding the expected 0.3% and pushing the year-over-year inflation rate to 3%. Investment-grade corporate bonds delivered positive returns, benefiting from the overall decline in yields, while high-yield corporate bonds gained 0.65%, reflecting continued confidence in corporate financial health.
Market expectations for Federal Reserve rate cuts in 2025 have fluctuated between one and three cuts as investors grapple with economic uncertainties. Meanwhile, Treasury Secretary Scott Bessent has emphasized the administration’s commitment to managing the 10-year Treasury yield, aiming to keep it below 5% to protect rate-sensitive sectors like housing and equities.
Rather than pressuring the Federal Reserve for rate cuts, the administration is focusing on fiscal measures, including deregulation, tax reforms, and energy cost reduction to naturally lower interest rates and stabilize the dollar. However, skepticism remains about these strategies, which could potentially prove inflationary and counteract efforts to contain long-term yields.
Economic Data and Outlook
The U.S. economy is showing signs of deceleration amid growing uncertainty around tariffs, immigration, government spending, and the Ukraine-Russia conflict. January’s economic data revealed concerning trends on multiple fronts.
The labor market showed signs of cooling, with nonfarm payrolls increasing by 143,000 in January, versus an expected 175,000. Despite this slowdown, the unemployment rate edged down to 4%, and real wage growth remained positive for the 21st consecutive month—a traditionally supportive factor for consumer spending.
However, January’s consumer expenditure data proved disappointing. Real personal consumption expenditures fell by 0.5%, the second-largest monthly decline of the current economic expansion. Durable goods spending dropped significantly, while services spending increased just 0.1% – the smallest monthly gain in two years.
The combination of weakening economic data and above-target inflation has raised stagflationary concerns. Trade policy uncertainty has surpassed levels seen during the 2018–2019 trade tensions, while the administration’s efforts to restructure the federal government and reduce spending could have a dampening effect on economic growth in the near term.
A potential government shutdown looms on March 14. While historically such events have caused only temporary market disruptions, this particular instance could have greater impact due to the Department of Government Efficiency’s active efforts to downsize the federal workforce. Equity markets typically decline modestly in the weeks preceding a shutdown but generally recover in the following months.
Investment Implications
While we believe the U.S. economy is slowing, with growth likely to decelerate in the near term, we are not overly concerned about a prolonged stagflationary environment. The combination of moderating demand and ongoing supply chain adjustments should allow inflationary pressures to gradually ease, albeit in a non-linear fashion. Inflation may remain above the Fed’s 2% target, but the economy should avoid a prolonged period of stagnation. We continue to monitor labor market health and consumer spending as key indicators.
In our fixed-income allocation, we maintain a preference for shorter-dated, high-quality bonds yielding above benchmark rates. The current environment features unusual volatility in
long-term bond yields, making yield predictions particularly challenging. Our approach prioritizes attractive absolute returns over attempting to time interest rate movements, focusing on generating reliable returns that align with broader investment objectives.
Regarding equity markets, we acknowledge that U.S. equity valuations remain elevated, which may constrain future returns relative to historical norms. However, we recognize that valuations are poor timing tools and may not necessarily revert to historical averages. This reinforces the importance of diversification, particularly through international equity exposure. The year-to-date outperformance of developed international stocks through February demonstrates the value of this approach.
Our investment strategy remains focused on navigating the complex interplay of economic deceleration, persistent inflation, and policy uncertainty through diversification and a disciplined approach to risk management. While near-term challenges exist, we maintain a constructive medium-term outlook predicated on the fundamental resilience of the global economy.
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