Unlike the first three quarters of the year, market results during the fourth quarter were substantially negative for stocks and positive for bonds. The trade conflict with China and the Federal Reserve’s persistent effort to follow through on “normalizing” monetary policy led to a significant pullback in the stock market and a corresponding rally in high quality bonds. We will expound below, but resolution to one or both issues will be necessary for stock markets to stabilize in 2019. If no resolution is reached, economic activity will likely slow and play into fears of the first recession we have seen in 10 years.
The start to 2018 was a continuation of a strong finish to 2017, which was fueled by optimism surrounding the tax reform plan. There was a clear pickup in GDP growth in 2018, which averaged 3.3% on an annualized basis over the first three quarters versus 2.5% for the first three quarters of 2017 .
Currently, there are conflicting signals coming from both the economy and markets. On the positive front, employment figures continue to surge with over 2.6 million jobs created for the year. This resulted in a 3.9% unemployment rate, reportedly the lowest level since 1969. Wages are increasing, albeit not fast enough to trigger a legitimate inflation problem (the Fed’s favorite gauge of inflation is still below target and expectations are falling). Job openings exceeded the number of job seekers, according to the U.S. Secretary of Labor, the first time in history. Earnings for companies in the S&P 500 should grow in the mid-single digit range for 2019 versus the 20% advance in 2018. Consumer confidence remains in the top quintile which demonstrates that the key driver of the economy (the consumer) is still feeling positive and retail activity should follow suit. The fourth quarter estimate for GDP, according to the Atlanta Fed’s GDPNow forecast, is positive 2.6%.
On the negative side, trade negotiations with China seem to be causing major swings in investor sentiment. The yield curve has inverted in the short-term portion of the market. If the Fed pushes ahead with their announced rate hikes in 2019, we will likely see inversion from the 2-year sector to the 10-yr sector. Yield curve inversion (where short-term yields are higher than long-term yields) has occurred 6-18 months prior to nearly every recession. Two of the largest and most interest rate sensitive sectors of the economy, housing and automobiles (where consumers typically borrow to make purchases), have shown weakness. The manufacturing sector is just barely expanding, according to recent ISM (Institute for Supply Management Survey) readings. U.S. debt levels are excessive (over $21 Trillion) and growing with trillion-dollar deficits for the foreseeable future. And finally, we have a Federal Reserve apparently intent on “tilting at windmills” over inflationary pressures that do not seem evident to the market.
These conflicting signals have translated into uncertainty and thus volatile markets. As we have written about before, the Federal Reserve has raised the overnight rate eight times since late 2015, and has initiated the reduction of its balance sheet that was expanded to fund stimulus during the Financial Crisis. The resulting effect has drained excess dollars from the economy and by design has slowed down growth. At the same time trade tensions have created difficult business conditions in several industries. Most of these positive and negative indicators we listed are backward looking. Investors, as represented by the global markets, do not have the same view as the Fed regarding future economic growth nor inflation. We hope the Fed re-evaluates its restrictive monetary policy until these uncertainties play out.
The S&P 500 posted a weak Q4, falling -13.5% for the quarter. Last quarter we mentioned that the U.S. equity market was one of the only positive asset classes across the globe. That changed during Q4, with the S&P 500 finishing the year down -4.4%, joining most all asset classes in negative territory for the year. In fact, according to the chart below, a record share of asset classes were negative in 2018. Global growth concerns, driven by tighter monetary policy, tariff & trade disputes, and investor sentiment souring, led to the weak results.
During Q4, U.S. equity markets briefly entered a bear market, falling 20.1% from an intraday peak (of 2,941) on September 21 for the S&P 500, to a 2,351 close on Christmas Eve. One trading day later (December 26) U.S. equity markets produced ~5.0% gains, including the largest point gain ever for the Dow Jones Industrial Average (+1086 pts).
Looking at the sector-level performance for the fourth quarter, ten of the eleven economic sectors in the S&P 500 posted negative results. Less cyclical, traditionally defensive sectors held up better during this market downturn. The Utilities sector was the only positive performer in Q4 (up 1.4%). Utilities also posted a positive full year performance (up 4.1%). Other defensive sectors such as Real Estate (down 3.8%), Consumer Staples (down 5.2%) and Healthcare (down 8.7%), also held up relatively well this quarter. In addition, the Healthcare sector posted the best full year results (up 6.5%).
The areas of the market that performed the worst in Q4 were the more cyclical, global growth-dependent sectors. Energy (down 23.8%) along with Technology & Industrials (both down 17.3%), were the three worst performers in Q4. The Energy sector also finished as the worst performing sector of 2018 (down 18.1%). Oil prices were down over 20% in 2018, with all of the weakness coming in Q4 (down 40%). Q3 concerns around supply shortages were short-lived after the administration granted waivers for oil imports from Iran, and U.S. shale oil producers continued to pump at record levels. Oil demand, related to a slower global growth environment, became a new concern and inventories began to build, sending prices lower.
The good news is that equity markets have priced in a significant slowdown, if not a recession, and valuations have contracted. According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is now 14.4x, which is below both the 5 & 10-year averages. Earnings growth for 2018 should come in around 20%, with consensus estimates calling for an additional ~7.5% growth in 2019 (though that figure has been coming down). We will continue to monitor central bank activity, trade disputes, along with political concerns (Brexit, shutdowns, etc.). Positive resolutions on these fronts would be welcomed news to equity investors and could prolong this already lengthy economic recovery. Looking back to the most recent bear market, which occurred during the 2nd half of 2011, the S&P 500 posted 19 separate moves of +/- 5.0% in a relatively short window of time. In short, the current volatility is to be expected and we expect it to remain elevated until some of the aforementioned issues are resolved.
In somewhat of a trend reversal, investment grade bonds led the way higher during the quarter. The Barclays Intermediate Government/Credit Index returned 1.59% for the quarter, and was up 0.77% for the year. The S&P Municipal Index was up 1.52% for the quarter and 1.36% for the year. These two asset classes were two of the very few that were positive in 2018. The traditional “flight to safety” into high quality fixed income investments was a direct result of the above mentioned equity market volatility. Yields dropped (prices rose) rather dramatically given the tone of the fixed income market for most of the year. The 10-year U.S. Treasury yield ended the year at 2.66%, down from a cyclical high of 3.23% in early November.
At least temporarily, the fear of runaway inflation appears to be fading, as the Fed’s favorite gauge of inflation, the Core Personal Consumption Expenditures (PCE), recently registered a muted 1.9% (see chart to the left). Keep in mind the Fed’s target for this reading is a range around 2%. Additionally, anticipations have recently reversed and the expectation is for lower inflation.
We believe these trends changed on October 3rd, when Fed Chairman Jerome Powell was quoted as saying the Fed Funds Rate was not near neutral, and he expected to go past neutral. While he walked back these comments in subsequent press conferences, the market was not allayed. While it is counterintuitive to see long term rates fall when the Fed is increasing the short end of the curve, the market is signaling monetary policy is getting too restrictive and may be a headwind moving forward and could curtail economic growth. A confirmation of this concern can be seen in the current shape of the yield curve. In the chart to the left, the blue line was the shape of the yield curve at year-end. One-year rates were higher than three-year rates. While not the traditional recession indicator (2s to 10s), the bond market is not in agreement with the current monetary policy and is concerned the negative forces mentioned earlier will translate to materially slower economic growth than what the Fed projects, and therefore lower inflation.
One opportunity that is developing in the bond market that we are keeping a close watch are the spreads in the corporate bond market. Our strategy for the past few years has been to avoid credit exposure in favor of government/municipal related instruments as the extra yield that has been available did not, in our view, compensate for the additional risk to own a corporate bond. While we still have not achieved a compensatory level that we are comfortable with, the chart above illustrates that spreads are widening, and if this trend continues we may well add to this asset class in the coming quarters.
Clearly a bearish narrative has taken root, which is why there has been constant “selling into strength” since October versus the constant “buying-the-dip” through September. That narrative incorporates what we have already discussed, an increased risk of a monetary policy mistake and misgivings about the U.S. and China working out a trade agreement. Ultimately both concerns point towards the risk of a recession. We believe the market has already priced in a slowdown in growth and possibly a mild recession. In other words, the worst may be behind us. Overall, we are lowering the risk in the equity portfolios on the margin and managing interest rate risk in our bond portfolios. In the meantime, we continue to follow the developments mentioned above and do our due diligence on the assets that we own to do our best to weather this environment.