Shifting Price Action as January Ends and February Begins

January closes and February begins with puzzling price movements in financial markets. Flows remain concentrated in the largest market-cap tech stocks, while smaller, economically-sensitive cap stocks underperform despite solid economic data. Paradoxically, while better data supports earnings, it also pushes yields higher, which markets interpret as an increased risk for small caps and other cyclically sensitive proxies.

Concentration in Tech and Communication Sectors

Among the eleven S&P 500 sectors, only Technology and Communications have outperformed this year. This narrowing of market breadth is typical during a “safety trade” regime ahead of an anticipated economic slowdown. However, the unusually extreme narrowing coincides with economic data like payrolls, unemployment claims, and GDP that seem to counter recession fears. Despite these signals, markets remain positioned for economic stress.

Signals of Economic Strength Versus Market Stress

The widening gap between economic strength and market stress is evident. Leading indicators such as yield curve inversion, ISM manufacturing contraction, declining employment breadth, reduced capital expenditures, lending cutbacks, and margin pressures keep recession concerns alive. While markets remain cautious, the persistent volatility and revisions in data complicate clear narratives.

Policy Responses and Market Liquidity

Market signals like banking stress or tighter funding conditions often prompt fiscal and monetary authorities to intervene. Despite the Federal Reserve maintaining high policy rates and shrinking its balance sheet, it is simultaneously providing liquidity to the financial system. This liquidity supports risk assets, treasury markets, and debt refinancing, crucial for a highly leveraged economy with limited demand for new borrowing.

Implications for Asset Allocation

Understanding the narrative and mechanics of the economy and markets is key for effective asset allocation. Recent banking stress tied to commercial real estate markdowns suggests the Federal Reserve may struggle to maintain tight policies much longer. In an election year, political motivations may further hinder fiscal restraint.

Watching Interest Rates and Fiscal Deficits

Stubbornly high interest rates are under close scrutiny. The U.S. faces record-high borrowing levels by peacetime and cyclical standards. Any additional pro- or counter-cyclical spending could provoke a bond market revolt, given the already staggering deficits relative to GDP.