Financial markets experienced a bout of rather extreme volatility during the fourth quarter sending US stocks to their worst year since the 2008 financial crisis. The current backdrop is seemingly far different however, as most economic data remains positive. Nevertheless, the aging bull market in equities gave way to increasing worries of slowing global growth, while political instability, including the government shutdown going into the holidays, has added fuel to the volatile environment.
US economic growth continues to be robust as GDP was up 3.4% for the third quarter of 2018, following the 4.2% growth experienced during the second quarter. While growth is expected to decelerate in the fourth quarter, it is anticipated the US will have its first calendar year of greater than 3.0% economic growth since 2005. As we move into next year cautious views become more prevalent, largely focusing on the Federal Reserve’s forecast of growth slowing to around 2%, while some economists have begun to initiate calls for a recession in the near future.
Manufacturing activity remains robust for the time being. The Institute for Supply Management’s Purchasing Managers Index registered an impressive 59.3 in November, which was also the 115th consecutive month of growth for the overall economy. A reading above 50 indicates that the manufacturing economy is expanding; below 50 indicates contraction.
The employment situation continues to show strength, with the most recent unemployment rate at 3.7%, a level last seen in the 1960s, and the economy adding roughly 200,000 jobs per month during the past year. Filings for unemployment benefits continue to hover near multi-decade lows, and the tight labor market has resulted in rising wage growth throughout 2018.
Buoyed by the employment situation, consumer confidence remains elevated by historical standards, but December’s reading dropped at a steeper than expected pace, slipping back to levels last seen in July. Importantly, the expectations component of the index fell sharply, indicating that while consumers are largely content with the current situation, more are growing concerned about the future.
Despite the relatively strong state of the consumer, the housing market continues to show signs of weakness. Pending home sales have declined in recent months, and the rate of increase in housing prices has moderated. It appears that elevated home prices coupled with higher mortgage rates have begun to keep more Americans on the sidelines of the housing market.
Alongside many risk assets, global oil prices tumbled during the fourth quarter, posting their biggest quarterly loss since 2014. After reaching a multi-year high in early October, crude oil prices plunged into a bear market during the quarter as a flight from risk assets joined concerns on both the supply and demand side of the equation, pushing the price of WTI crude down to $45 per barrel, 25% below where it started the year.
Globally, the economic picture faces its share of challenges. Trade tensions, most notably between the U.S. and China, weighed on investor sentiment at a time when global economies are forecasted to slow. Although a détente of sorts was reached in December, the U.S. and China will hold trade talks again in January of 2019. Also complicating the global economic picture are the escalating uncertainties surrounding Brexit as the March 29 deadline for the United Kingdom leaving the European Union quickly approaches.
While the possibility of an economic slowdown is high on the list of investors’ anxieties, as of now the US consumer (which accounts for roughly two-thirds of US GDP) appears to remain on solid footing. In all, concerns are elevated but data shows growth is still positive, albeit slowing. Last but not least, investors will continue to monitor the events in Washington DC as a new Congress convenes.
The 10-year Treasury yield hit a seven-year high yield of nearly 3.24% in early November, before bond prices rallied amid the equity selloff, pushing its yield lower to close the year at 2.69%. This late-year rally in the price of bonds pushed the broad bond market into positive territory for the fourth quarter and essentially a flat total return for 2018. Credit spreads on both investment grade and high-yield bonds widened to their highest level in over two years amid economic jitters, pushing returns on most corporate bond indices to negative levels for the year.
As the chart below shows, government bond yields ended higher across the board than where they began the year, however the move up in yields was far more pronounced on the short-end which led to a general flattening of the yield curve. While the closely watched 2-year to 10-year yield curve has not yet inverted (when short-term interest rates exceed those on longer-term securities) investors will continue to monitor that relationship closely as it has been a consistent indicator of a looming economic recession.
As expected, the Fed raised rates by 25 basis points to a range of 2.25%-2.50% at its December Federal Open Market Committee meeting. This most recent rate increase marks the fourth rate increase this year and the ninth since the Fed began to lift rates in late 2015. The statement that accompanied the rate hike indicated that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. It was also stated that some further gradual increases in the target range would be consistent with sustained economic expansion. Finally, the Fed noted that the risks to the economic outlook are roughly balanced.
Going forward, investors will be focused on the Fed’s policy path in 2019 and any signs of changes in inflation expectations. Interestingly, the futures market currently prices in no additional hikes for 2019, despite projections released after the meeting show that most Fed officials expect to increase the Fed Funds Rate an additional 0.50% over the next twelve months.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 12/31/18)|
|Barclays Capital US Aggregate||0.01%||Merrill Lunch US High-Yield||-2.25%|
|Barclays Intermediate Government||1.43%||Merrill Lynch US Municipal Index||1.05%|
|Dow Jones Corporate||-2.69%||JP Morgan EMBI Global||-4.61%|
Major market averages posted steep losses for the quarter, punctuated by a roughly 9% fall in December for each the Dow, NASDAQ, and S&P 500. The sell-off was the worst December for the S&P 500 and Dow since 1931, and the biggest monthly loss in nearly a decade. The markets went through dramatic swings during the quarter, with S&P 500 teetering on the edge of bear market territory after a sharp Christmas Eve sell-off, only to see a the biggest one-day rally in nearly a decade on the next trading day. The surprising rout in stock prices during the quarter erased gains that domestic indices had posted through the first three quarters of 2018 and pushed international markets even lower. The factors driving the volatility appear to be more macro in nature, as underlying earnings reports were largely favorable. In fact, the key worry among equity investors appears to center on whether stocks have reached “peak earnings” and if downward revisions are around the corner.
For the quarter, the S&P 500 dropped 13.5%, the Dow 11.3%, and the NASDAQ Composite fell 17.3%, all accounting for the worst quarters since the 2008/09 time period for the major market indices. The fourth quarter sell-off pushed 2018 calendar returns for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all into negative territory. Growth stocks gave back some of their gains relative to value stocks during the quarter, but still were in favor by a wide margin for the year, ending 2018 essentially flat, versus a 9% drop in the S&P 500 Value Index. Domestic small-cap and mid-cap stocks fell more than their large-cap counterparts during the fourth quarter, and both the S&P Midcap 400 Index and the Russell 2000 Index (small-cap) ended 2018 with a loss of 11%.
The fundamentals of corporations are still strong for the time being. US companies have benefited from a strong economy and lower tax rates, and quarterly profits again grew at a greater than 20% clip. Fourth quarter earnings are expected to be robust as well, but investors have turned their attention to 2019 earnings where a deceleration in the growth rate is widely anticipated. Factors expected to contribute to the projected slowing earnings growth include the waning effects of fiscal stimulus and the unresolved trade battle. On a positive note, the market may have priced in this deceleration to some degree, with the S&P 500 closing the year trading between 15-16 times expected 2018 operating earnings, a level that is roughly in-line with historical averages.
Turning to international equities, there was no shortage of political drama spanning from Brexit developments to global trade turmoil. The Eurozone continues to show low (albeit positive) growth and inflation statistics, while Japan felt an economic contraction in its most recent quarter. Ahead of anticipated trade talks with the US, China’s growth has been slowing but was last reported to remain around the 6% level. Other emerging markets remain volatile and can be influenced by currency and commodity prices. Against this backdrop, the benchmark for developed international equities fell 12.5% for the quarter and emerging markets dropped 7.6%. While international stocks fared better than US equities on a relative basis for the quarter, both developed foreign and emerging market equities ended 2018 with double-digit losses.
|Equity Indices||4th Quarter 2018|
|Dow Jones Industrial||-11.31%|
|S&P 500 Growth||-14.71%|
|S&P 500 Value||-12.05%|
|Russell 2000 (small-cap)||-20.21%|
|MSCI/EAFE (developed international)||-12.49%|
|MSCI/EM (emerging markets)||-7.60%|
In concert with the plunge in oil prices, the Energy sector led the market lower, dropping nearly 24% over the past three months. The overall equity sell-off was broad-based, with the more cyclical sectors including Industrials, Technology, and Consumer Discretionary all posting losses greater than the market in general during the quarter. As might be expected during a sell-off, the traditionally defensive and lower-beta Utilities sector led the market during the quarter, posting a slight gain amid the market turmoil. Real Estate, Consumer Staples, and Health Care also outperformed on a relative basis.
The following table details S&P 500 sector total returns for the quarter.
|Return by Stock Sector||4th Quarter 2018|
|2. Real Estate||-3.84%|
|3. Consumer Staples||-5.22%|
|4. Health Care||-8.72%|
|7. Communication Services||-13.19%|
|8. Consumer Discretionary||-16.42%|
|10. Information Technology||-17.34%|