FINANCIAL MARKET COMMENTARY
2018: THE YEAR WHEN NOTHING WORKED
Although financial markets fluctuate, there are usually winners and losers each year. The year 2018 will be remembered as the year when nothing worked. Excluding cash, treasury bonds, and municipal bonds, every major asset class either lost money or posted 0% gains last year. The majority of the losses occurred in the 4th quarter, as several events occurred:
President Trump openly criticized the Federal Reserve Chair during a period when the Fed raised interest rates two times (9/27 and 12/19), and began shrinking its balance sheet by letting bonds on its balance sheet mature. The last time a sitting President criticized the Fed was 1984, when Reagan asked Paul Volker not to raise rates before the election.
The 3rd quarter corporate earnings season was strong (32% growth vs. last year). However, many companies forecast slower growth moving forward as the impact of the $500 billion corporate tax cut enacted at the beginning of the year has run its course.
The yield curve, a chart of treasury bond yields across various maturities, began to invert (one-year bonds yielded more than 5-year bonds), which stoked recession fears.
Tensions over US trade with China reached a boiling point as the US increased its threats of tariffs on $50 billion in goods to $200 billion. The countries agreed in December to put tariffs on hold while a deal is negotiated.
Stocks in the US nearly reached “bear market” territory in the 4th quarter, with the S&P 500 index losing 14% of its value. Small Cap stocks were the biggest losers with losses of 20%. For the first time all year, international and emerging market stocks outperformed the US in the 4th quarter.
After posting losses all year, bonds rallied in the 4th quarter to post tepid gains. In particular, high quality government bonds like US treasuries and municipals were the best performers in bond world. High yield and emerging market sovereign bonds denominated in dollars declined in the 4th quarter.
Commodities were hammered in the 4th quarter (-23%), turning index performance negative for the year. Oil prices dropped by nearly 40% in the 4th quarter. Gold rallied by 7% in the 4th quarter despite posting losses of 3% for the year.
The Momentum View: The Market Has Overreacted. Will You?
There is an old joke among economists: The stock market has predicted 9 of the past 5 recessions. In other words, stock market performance is not a good indication of the direction of the economy. The recent slide in global stock markets certainly has made investors nervous. During times like this, we must look at fundamental data for answers. Here is what we are seeing:
EARNINGS. Corporate earnings in the US grew by over 26% for the first 3 quarters of 2018. This is the most profit growth we’ve seen since 2010. This growth would rank in the top 20% of all readings in the past 40-years.
VALUATIONS. While earnings have grown, the stock market has declined in value, bringing the forward Price to Earnings multiple on the S&P 500 to a level of 14x compared to its long-term average of 15.8x.
LATE CYCLE RETURNS. Research shows that the last 12-24 months before a recession have historically produced double-digit equity returns.
STRONG ECONOMIC DATA. Despite an economic expansion that is among the longest in history (currently 114 months), we are still seeing positive data.
The economy added over 300,000 jobs in December vs. an average of 215,000 per month in the past 5-years.
Hourly wages grew by 3.2% in 2018, the largest gain in 10-years.
YIELD CURVE. The yield curve has accurately predicted every recession since 1969. The yield curve is months away from “inverting,” leaving short-term interest rates higher than long-term rates. The difference between 2-year treasury yields and 10-year yields is currently around 0.18% vs. 0.50% a year ago.
BUDGET DEFICITS. The US government has a debt problem. The government shutdown that began in late-December is the longest in US history and centers around deficit spending – specifically for funding a $5.7 billion wall at the Mexican border. We are borrowing nearly $1T per year, or 22% of our $4.5T annual budget. Before the tax cuts, we had a 17% deficit. Not only are we going deeper in debt, our interest payments are rising as interest rates creep higher.
STAGFLATION RISKS: Stagflation is the combination of slow growth and high inflation. While we believe this risk is extremely low, we are seeing slower GDP growth globally and rising wages and tariffs could cause inflation.
We believe the stock market has overreacted. The strong bounce-back we are seeing in early-January supports this view. In our estimation, stocks are fairly valued, the US consumer is still spending money, and the Fed will be flexible in its approach to managing interest rates. Corporate earnings growth will not be as strong in 2019 as the prior year, but we do not think it will be as bad as feared. In summary, we are beginning to recommend that clients rebalance their portfolios, which means buying more stocks. To balance equity risk, we advise clients consider higher quality bonds and alternative investment vehicles with low correlations to the stock market. We still believe in diversification over the long-term, although we acknowledge it is no insurance against losses in the short-run.
Leading Indicators of the Economy Point to Continued Growth
The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. The index includes forward-looking data such as unemployment claims, inventories, manufacturer shipments, housing starts, inflation and consumer confidence. The index tends to approach a reading of 0 when a recession is imminent. The grey bars below represent recessions.