U.S.

The S&P 500 Index fell to its lowest level since June 2021 as investors reacted to Russia’s invasion of Ukraine and worried about higher inflation and interest rates. Communication services and information technology were among the worst-performing sectors, dragged lower by declines in mega-cap growth stocks. Energy stocks escaped the downdraft and managed a healthy gain as fears over sanctions against Russian oil and natural gas exports drove energy prices to their highest level in eight years. The losses temporarily pushed the S&P 500 into a correction, or down over 10% from its recent highs. The Nasdaq Composite Index and small-cap Russell 2000 Index finished the month down 16% and 17% from their peaks, respectively.

U.S. Treasury bond prices fell on inflation worries early in the month, although yields later decreased as investors sought the perceived safety of government bonds and the U.S. dollar in the aftermath of the Russian invasion. (Bond prices and yields move in opposite directions.) The same risk-off sentiment weighed on credit-sensitive bonds, but high yield corporate bonds proved resilient thanks to the heavy weighting of energy issuers in the asset class.

Inflation Worries Pressure Stocks Early in the Month

Inflation worries, particularly concerns about the development of a wage-price spiral, also seemed to dominate sentiment in the equity market as the month began. On February 4, the Labor department reported healthy job growth in January despite the spread of the omicron variant of the coronavirus, while average hourly earnings jumped 0.7%. The following week, the department reported that headline consumer price index inflation advanced 7.5% over the year ended January, more than consensus expectations and its highest annual rate since February 1982. Core prices, which exclude food and energy purchases, rose 6.0%, the most since August 1982. Inflation worries pushed the University of Michigan’s gauge of consumer sentiment to its lowest level in over a decade.

Russian Attack Upends Expectations

The data raised expectations that the Federal Reserve would aggressively raise rates to temper inflation, but warnings from U.S. and Ukrainian officials at mid-month that Russia was preparing to attack upended growth and inflation expectations. The breadth of the invasion that began on February 24 took investors further by surprise. News of attacks on the capital, Kyiv, and other major cities sent stocks sharply lower—at its low at the start of trading February 24, the S&P 500 Index hit 4,115, roughly 15.5% below its peak at the start of the year, putting it firmly in correction territory.

Setbacks for Russia in the invasion and news that the two sides would begin negotiations sparked extreme volatility as the month came to an end. Bond yields increased and stocks rallied sharply following news that Russia was prepared to send a delegation to Belarus for talks. Investors may have also been reassured that initial Western sanctions against Russia were not as severe as some feared, particularly regarding its energy sector. The announcement of further tough sanctions took the steam out of the rally on the final day of the month, however.

Growth Appears to Accelerate as Omicron Ebbs

While geopolitics dominated sentiment, some positive earnings surprises and economic signals may have cushioned the month’s declines. Retail sales rebounded more than expected in January, up 3.8% for the month following December’s 2.5% drop. While omicron weighed on sales at gas stations and restaurants/bars, online retailers and furniture stores saw large spending gains. An easing in omicron trends seemed to result in the economy regaining momentum early in February, with IHS Markit’s composite gauge of service and manufacturing activity rebounding from an 18-month low. Services activity drove the rebound, but manufacturing output also improved, benefiting from a slight easing of supply bottlenecks.

Europe

Shares in Europe fell sharply after Russia invaded Ukraine, raising fears of higher inflation and economic weakness. In local currency terms, the pan-European STOXX Europe 600 Index ended more than 3% lower. Major indexes also dropped, with Germany’s DAX Index giving up more ground than France’s CAC 40 Index and Italy’s FTSE MIB Index. The UK’s FTSE 100 Index was little changed.

ECB Officials Signal Delay to Policy Changes After Invasion of Ukraine

Hawkish European Central Bank (ECB) policymakers discussed a faster end to generous asset purchase programs—some even advocated for two possible interest rate increases this year—to curb soaring inflation. ECB President Christine Lagarde and some of the more dovish policymakers sought to play down these expectations, emphasizing that any adjustment to monetary policy would be gradual and guided by economic data. After Russia invaded Ukraine, Lagarde said the ECB is ready to do “whatever is needed” to ensure price and financial stability in the euro area. Several of the more hawkish officials signaled the potential for a delayed exit from the central bank’s ultra-easy policy stance. ECB Chief Economist Philip Lane reportedly told fellow policymakers that, in a worst-case scenario, the war could knock 1.0% from eurozone gross domestic product (GDP) in 2022.

Eurozone GDP Growth Slows in Q4

The eurozone economy grew 0.3% in the final three months of 2021—a slowdown from the 2.3% expansion in the third quarter. This weakness appeared to stem from the surge in coronavirus infections, which weighed on economic activity. For the full year, the eurozone economy grew 5.2%, after a 6.4% slump in 2020. The data also showed that the bloc’s trade deficit in goods widened by a seasonally adjusted EUR 9.7 billion in December—the most since August 2008—due to soaring energy prices. The trade deficit with the bloc’s biggest energy supplier, Russia, rose to EUR 69.2 billion in 2021 from EUR 15.7 billion in 2020.

Separately, Eurostat data showed that the jobless rate fell to 7.0% in the eurozone in the final month of 2021, an improvement of 100 basis points (1%) compared with the downwardly revised November tally.

BoE Raises Rates for Second Meeting in a Row

In the UK, the Bank of England (BoE) raised its key interest rate, aiming to curb inflation that the central bank forecast could exceed 7% in April. Policymakers voted 5 to 4 to increase the bank rate by a quarter percentage point to 0.5%, with the minority wanting a half-percentage-point hike. They also voted unanimously to stop reinvesting the proceeds from maturing government bonds bought as part of the BoE’s quantitative easing programs. Expectations of a third interest rate increase in March were fueled by inflation surging to a 30-year high of 5.5%. However, the Russia-Ukraine situation appeared to prompt traders to cut back their bets.

Japan

Japanese stocks generated a negative return in February, with the MSCI Japan Index falling -1.15% in local currency terms. The conflict between Russia and Ukraine and the anticipation of more aggressive monetary tightening by the U.S. Federal Reserve weighed on sentiment. The government announced the first phase of easing Japan’s border control measures—among the strictest in the developed world—allowing the entry of some foreigners (but not tourists) from March 1. Buoyed by strong private consumption amid falling coronavirus cases, the Japanese economy grew by an annualized 5.4% quarter on quarter over the final three months of 2021, having contracted by 2.7% in the third quarter of the year.

Bank of Japan (BoJ) Retains Its Dovish Stance

On the monetary policy front, the BoJ acted to curb rising Japanese government bond (JGB) yields, which rose to their highest level since 2016 early in the month, primarily due to global inflation risks and higher U.S. Treasury yields. Investor speculation about prospective policy normalization by the BoJ has increased as other major central banks have tightened monetary policy amid a buildup of inflationary pressure in the global economy. However, BoJ Governor Haruhiko Kuroda has continued to assert that, with inflation in Japan remaining well below the central bank’s 2% target, the central bank will retain its dovish stance. The yield on the 10-year JGB finished the month broadly unchanged at 0.18%. The yen strengthened to around JPY 114.99 against the U.S. dollar, from JPY 115.13 at the end of January.

Japan Announces Sanctions Targeting Russia

In response to Russia’s initial infringement of Ukraine’s sovereignty and territorial integrity, whereby it recognized as independent the breakaway regions of Donetsk and Luhansk and authorized the sending in of troops, Japan adopted a first set of sanctions, addressing the issue in cooperation with the international community. A second set of sanctions, more stringent and closely coordinated with the U.S. and Europe, was announced following Russia’s invasion of Ukraine. This included export controls on semiconductors and other high-tech products, a freeze on some Russian banks’ assets, and a suspension of visa issuance for certain Russian individuals and entities.

Japan also joined the international sanctions on Russia’s central bank by limiting transactions with it and blocked certain Russian banks’ access to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), an international banking and messaging network. On the latter decision, Prime Minister Fumio Kishida said that the government will cooperate with the private sector to limit its impact on small and medium-sized companies and financial institutions. He also said that Japan had enough oil and gas reserves to cushion any short-term blow to energy supplies and that the government would implement measures to limit the impact of further rises in the oil price. The country will work in cooperation with international partners to stabilize the crude oil market, and Kishida believes that the current situation will not immediately pose a major obstacle to the stable supply of energy.

China

Chinese stocks ended February on a mixed note. The MSCI China Index fell 3.9%, while the MSCI China A Onshore Index added 2.75%. In domestic markets, the large-cap CSI 300 Index added 0.4%. The renminbi rose 0.86% against the U.S. dollar to RMB 6.311, its strongest level since April 2018, as traders appeared to view the Chinese currency as a “safe haven” currency at a time of global crisis.

The yield on the 10-year Chinese government bond ended at 2.81%, up nine basis points from the prior month-end. The People’s Bank of China left its key one-year and five-year loan prime rates unchanged, though most analysts expect easing in the coming months. Growth in bank loans, total credit, and money supply in January exceeded forecasts, signaling some success in the central bank’s efforts to boost lending.

Struggles Continue in Property Sector

News from cash-strapped developers continued to highlight the debt difficulties weighing on China’s property sector. Sales for the 100 biggest companies in the property industry slumped 39.6% in January from a year ago, compared with December’s 35.2% decrease, according to the China Real Estate Information Corp. Chinese property developers need to repay almost USD100 billion of debt this year, Bloomberg reported. New home prices edged higher in January, their first monthly increase since September, though analysts said that downward pressure on existing home sales persisted in lower-tier cities. In response to the slowdown, China’s government pledged to keep the real estate market stable this year, as evidenced by a series of easing measures.

In economic readings, the Caixin manufacturing purchasing managers’ index (PMI) fell back into contractionary territory in January. The services PMI reading weakened as pandemic restrictions weighed on consumer activity and sentiment, though it remained in expansionary territory. Consumer price inflation fell to 0.9% in January from 1.5% in December as food prices fell, while core inflation held at 1.2%. China’s latest inflation data and the central bank’s dovish comments reflected the country’s growing macro and policy divergence with the U.S., where the Fed is seen repeatedly hiking interest rates this year. Beijing plans to set an official 2022 economic growth target of around 5.5% at the annual National People’s Congress in March, supported by a raft of fiscal easing measures, according to Chinese state media.

On the pandemic front, many provinces across the country continued to experience outbreaks. Although case numbers remain relatively small, China has found the omicron variant harder to stamp out, with outbreaks reported in the provinces of Guangxi, Inner Mongolia, Liaoning, and Jiangsu.

Other Key Markets

Investors Flee Russian Stocks

Stocks in Russia, as measured by MSCI, plummeted 52.75%. Russian assets declined in value throughout the month as the country’s military continued its multi-month buildup along Ukraine’s borders with Russia and Belarus. While the government insisted that it had no intention of invading Ukraine, its leaders have demanded “security guarantees” that would, among other things, keep former Soviet republics from joining NATO.

Toward the end of the month, the Russian government formally recognized the self-proclaimed “Donetsk and Luhansk People’s Republics” in eastern Ukraine as independent states. Those regions have been unsettled since pro-Russian separatists seized control of them in 2014. Russian President Vladimir Putin also dispatched “peacekeeping” troops into the breakaway regions; shortly thereafter, he ordered a “special military operation” to “demilitarize” Ukraine. Russian forces, striking from Russia, Belarus, Crimea, and the Black Sea, attacked military targets in a number of Ukrainian cities.

Various nations around the world condemned Russia’s actions, and the U.S., the UK, and other European powers made good on their promises to immediately implement new sanctions in response. While each country’s sanctions vary, the initial sanctions generally targeted a number of key Russian individuals and financial institutions. They included measures such as freezing assets and prohibiting transactions with certain Russian businesses, and most of the Russian banking system lost the ability to settle international transactions. Also, in the U.S., there was a ban on American firms and individuals trading and investing in the secondary market of new Russian government debt.

As the month ended, the U.S., Canada, and various European nations decided to cut off several Russian banks from SWIFT. In addition, sanctions were issued on Russia’s Ministry of Finance, central bank, and National Wealth Fund, prohibiting transactions with these institutions and effectively “freezing” reserves in their respective jurisdictions. In response to a crash in the ruble versus the U.S. dollar, the central bank boosted short-term interest rates to 20%, imposed a temporary ban on nonresident investors holding Russian financial assets, and took other actions in an attempt to soften the impact on Russia’s financial system.

Stocks Gain in Brazil

Stocks in Brazil, as measured by MSCI, returned 4.70% versus -2.98% for the MSCI Emerging Markets Index. Elevated inflation and monetary policy expectations were some of the main drivers behind Brazilian financial market performance. As the month began, the central bank decided, as was generally expected, to raise the key lending rate by 150 basis points, from 9.25% to 10.75%. In addition, as anticipated by T. Rowe Price sovereign analyst Richard Hall, policymakers signaled their intention to downshift the pace of rate hikes. According to the post-meeting statement, central bank officials said that they foresee “a reduction in the pace of adjustment of the [policy] interest rate. This indication reflects the stage of the tightening cycle as its cumulative effects will manifest themselves over the relevant horizon.” Hall noted that the language was ambiguous, as it does not clearly project the size of the next rate increase as previous post-meeting statements have. However, this gives the central bank flexibility regarding its next monetary policy move, particularly if inflation remains elevated. In any event, Hall believes that Brazil’s inflation is plateauing at an elevated level and that signs of disinflation are not likely to become apparent until sometime in the second or third quarter of this year.