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U.S. and Canadian stocks posted their worst performance of the year on Tuesday, with the main benchmarks ending down as investors interpreted a rebound in U.S. business activity in February to mean interest rates will need to stay higher for longer to control inflation.

For the S&P/TSX Composite Index, S&P 500 and Nasdaq Composite, it was their third session in a row closing lower, while the decline in the Dow Jones Industrial wiped out its gains for 2023.

The falls came after the S&P Global Purchasing Manufacturer’s index, which reflects business activity in the United States, returned to expansion for the first time in eight months in February. The 50.2 reading, up from 46.8 in January, was buoyed by a robust services sector, according to a survey.

The report added to a recent slew of economic data which has painted a picture of a resilient economy, which continues to perform against a backdrop of multiple rate-rises by the central bank in 2022 aimed at tamping down inflation.

With inflation still far from the Fed’s 2% target, and the economy retaining much of its vigor, money market participants have been revising upwards where they see the Fed fund rates peaking - currently at 5.35% in July and staying near those levels throughout the year.

“Today, the realization is that the Fed is not kidding around about higher for longer, and in fact it might be a little bit higher for a little-to-a-lot bit longer,” said Carol Schleif, chief investment officer at BMO Family Office.

U.S. stocks had an upbeat start to the year after their worst annual showing in more than a decade in 2022, as investors hoped the central bank’s rate-hike cycle was nearing its end. Such positivity makes equity markets susceptible to pull-backs though, when data undermines such expectations.

“The market keeps looking for a dovish pivot, and they are just not going to get it,” said Schleif.

Investors will look to the minutes detailing discussion at the Fed’s last policy meeting, due out on Wednesday, for further clues on attitudes within the central bank on rates.

The Dow Jones Industrial Average fell 697.1 points, or 2.06%, to 33,129.59, the S&P 500 lost 81.75 points, or 2.00%, to 3,997.34 and the Nasdaq Composite dropped 294.97 points, or 2.5%, to 11,492.30.

In Toronto, the TSX ended down 262.60 points, or 1.28%, at 20,252.64, its biggest decline since Dec. 15 and its lowest closing level since Jan. 12. It was a broad decline, with all major sectors losing ground. Financials lost 1.3%, energy 1.4% and technology 1.6%.

Statistics Canada released tamer-than-expected inflation numbers for January, which added further weight to the Bank of Canada’s plans for a ‘conditional pause’ on further interest rate hikes. It showed the annual rate of inflation easing to 5.9%, versus Street forecasts of 6.1%.

But both stocks and bonds largely took their direction from the U.S. The Canada 5-year bond yield - influential on fixed mortgage rates - rose to 3.615% by late afternoon, up about 15 basis points and its highest since November

Benchmark U.S. 10-year note yields reached 3.962%, the highest since Nov. 10. They are up from a four-month low of 3.321% on Jan. 19.

Among stocks hit by Tuesday’s widespread declines were big tech stocks, with Tesla Inc, Inc, Microsoft Corp and Google-parent Alphabet Inc all falling between 2.1% and 5.3%. Higher yields typically weigh on growth stocks, whose valuations tend to be based on future profits that are discounted heavily as rates go higher.

The semiconductor index was also impacted, dropping 3.3%.

Elsewhere, Home Depot Inc slumped 7.1% to a three-month low after the No. 1 domestic home improvement chain warned of weakening demand and issued a dour profit forecast for 2023.

Smaller rival Lowe’s Cos Inc fell 5.1% ahead of its results next week.

Walmart forecast full-year earnings below estimates and painted a grim picture of hotter-than-expected food inflation squeezing profit margins. However, the world’s largest retailer rose 0.6%.

All of the major 11 S&P 500 sectors fell, with the consumer discretionary index’s 3.3% decline leading the way.

Volume on U.S. exchanges was 11 billion shares, compared with the 11.62 billion average for the full session over the last 20 trading days.

The S&P 500 posted two new 52-week highs and one new low; the Nasdaq Composite recorded 57 new highs and 112 new lows.

Reuters, Globe staff

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