Despite the US economy remaining solid with unemployment at historic lows and GDP and inflation in normal range, the fourth quarter of 2018 saw significant market swings and ultimately negative returns for US equities.
This reflects mounting concerns associated with a maturing economic cycle. Worries about Federal Reserve (Fed) policy and pockets of economic softness, along with political turmoil, trade disputes, and a partial government shutdown, prompted investors to sell US stocks across the board.
Developed international and emerging markets also moved lower reflecting uncertainty around ongoing trade disputes, weakening global economic data, declining oil prices, and a stronger US dollar. As often occurs during periods of substantial volatility, bond prices rose, reflecting increased investor demand for safer assets.
2018 Q4 Returns
Top Factors Impacting the Markets
Though US recession risks appear low, we expect continued market volatility in 2019 with many factors influencing global markets, with short- and long-term implications.
US Economic Activity
Through the fourth quarter, US economic data showed continued strength, but some consumer and business sentiment softened in December 2018. Sentiment signals consumer and business confidence toward the overall economy and their individual financial state. It can be an indicator of future spending and investment.
The labor market remained strong with unemployment at 3.9%, and the most recent Job Openings and Labor Turnover Survey (JOLTS) showed job openings rose to the second highest level since 2001. The quit and discharge rates—indicators of worker bargaining power—stayed near series highs and lows, respectively. Inflation remained contained in part due to falling energy prices.
During the fourth quarter, multiple business surveys did, however, depict declining levels of business activity as well as falling expectations for the future. Growth in industrial production and retail sales fell from midyear highs, giving rise to concerns that the positive growth trends in these areas may begin to reverse.
International Economic Trends
In general, levels of US economic growth remain robust, particularly relative to much of the rest of the world, which endured a slowdown over the past year. In December 2018, the Fed reiterated its target for US gross domestic product (GDP) growth in 2019 remains in the normal range of 2.5%.
In Europe, business activity, as measured by survey data, continued to weaken slightly. December data from all European countries showed declining economic situations. Eurozone industrial production continued to grow, albeit weakly, and growth was well off from early-year highs.
Economic data in China, while positive, came in at the weakest level in years. November readings of year-over-year industrial output growth and retail sales growth were the slowest since 2002. This was in part due to the effects of tariffs enacted by the United States. Weakness in China led to slowdowns in many other emerging economies, a trend that could continue.
Interest Rates and the Yield Curve
Despite the large correction in equity markets, the data-driven Fed continues to believe the US economy is solid. On December 19, 2018, it raised rates at 0.25% for the fourth time for the year. The Federal Funds rate is now at a target range of 2.25%–2.50%.
In the US Treasury markets, prices on longer-term Treasury bonds increased, reflecting what’s known as a flight to quality, or a rotation into bonds that often occurs during a sell-off in equities. Bank of America Merrill Lynch’s December 2018 survey of 243 investors controlling around $700 billion in assets showed investor allocation to bonds jumped 23%, the largest ever one-month rotation into bonds.
Since the Fed began hiking rates in December 2015, long-term rates have risen much less than short-term rates, flattening the US Treasury yield curve. While long-term US Treasury rates can indicate investors’ expectations for future economic growth, they also reflect the global supply and demand for safe income. The increase in equity volatility was clearly a driver for some of the buying of US Treasuries during the fourth quarter.
Trade Wars and Tariffs
Trade tensions and tariffs, particularly between the United States and China, continued to provide uncertainty throughout the fourth quarter. Economic data in China has shown impairment stemming from the tariffs enacted early in 2018, and multinational juggernauts Apple and Federal Express recently cited disruptions in their business due to slowing global trade.
As 2019 begins, the two countries appear motivated to compromise. As of January, a plan is in place to hold vice-minister level trade talks between China and the United States. A US delegation is expected to visit China in January, the first meeting since presidents Donald Trump and Xi Jinping agreed to a 90-day truce in late 2018.
We retain a balanced view of asset returns relative to their risks. Early in 2018, the world enjoyed a confluence of synchronized global economic growth and pro-growth central bank policies in most major economies. The exception, however, was in the United States, which instead employed expansionary fiscal policy in the form of corporate and individual tax cuts with tax reform, commonly referred to as the Tax Cuts and Jobs Act, passed in late 2017.
The new year reflects a slightly more muted picture with some indications of slowing global growth, potential for further negative trade impacts, and waning of the pro-growth fiscal policy effects in the United States. Market volatility is expected as investors continue to price in the consequences of these events.
The US economy still appears in good shape though. The strong labor market, tame inflation, and lower oil prices give us confidence in consumer spending—the largest part of the US economy.
While the fourth quarter was quite volatile, global equities repriced lower in response to many of the risks mentioned earlier. From these current levels, we believe there’s durability in US corporate earnings, supported by mostly constructive economic fundamentals that can justify increased asset prices. We continue to believe emerging market equities, though currently under pressure, represent solid long-term growth prospects due to attractive valuations, a quickly growing middle class, and positive demographic trends.
While volatility will occur, it’s difficult to predict the timing or magnitude of any market shift. Investors can prepare by keeping a well-diversified portfolio. An allocation to alternative assets uncorrelated to the traditional stock and bond markets can reduce overall portfolio volatility and provide other sources of return in times of market stress.
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