Bears finally come out of Hibernation
To say 2018 was a challenging year would be an understatement. The S&P 500 experienced two 10% corrections, the second of which barreled straight into bear market territory (drawdown greater than 20%). This erased the 7.71% positive return we had experienced through September 30 to produce the worst calendar year return since 2008 of <-4.38%>. If not for the last week of the year rally, December was shaping up to be the markets’ worst month since the Great Depression in 1929. Even with said rally, we finished with returns on the S&P 500 of <-9.03%> for the month, and <-13.52%> for the year’s final quarter. Unfortunately, the uncertainty of the Fed’s monetary policy, US-China tariff negotiations, and weaker earnings guidance left investors with few places to hide. The NASDAQ (technology) and Russell 2000 (US small cap equities) sold off 17.54% and 20.20% for the quarter, to end the year down <-3.88%> and <-11.01%>, respectively.
While slowing growth, geopolitical tensions, and ongoing trade concerns continued to plague international markets, the final quarter of 2018 saw foreign equities hold up relatively well when compared to the US, with returns on the MSCI EAFE Index and MSCI Emerging Markets Index off <-12.5%> and <-7.40%>, respectively. Often overlooked with investing in foreign markets is the impact the US dollar has on returns. While the 2017 US dollar weakness added to the superior returns foreign markets achieved, the 2018 US dollar strength (up approximately 5%) helped compound the negative returns of foreign equities with developed and emerging markets finishing the year down <-13.36%> and <-14.25%>, respectively.
Typically when risk assets (equities, commodities, real estate, etc.) sell off, bonds should benefit from the subsequent move to quality. Unfortunately, for most of 2018, that wasn’t the case. In fact, it was the sharp increases in rates on the 10-Year Treasury that really served as the catalyst for volatility in the markets. In February, the 10-Year jumped from 2.4% to just under 3%, giving us our first 10 percent correction of the year. Again in October, the 10-Year accelerated from 2.9% to a high point of 3.25%. This sharp spike struck fear in investors that companies wouldn’t be able to run at a profit at such levels, and that the Fed might make a misstep as they transition from Quantitative Easing (QE) to Quantitative Tightening (QT). As volatility resumed in the equity markets, and concerns over a potential recession increased, a flight to safety dropped the 10-Year Treasury all the way back to 2.65% to close out the year, allowing the Barclays Aggregate Bond Index to scratch out a full-year return of 0.01%.
From the “Art of the Deal” to No Wall, No Deal
Trade talks between the US and China have resumed this week, and it appears Trump’s line-in-the-sand approach has taken a toll on China’s economy, perhaps giving the US an advantage in this round of negotiations. President Trump’s administration targeted China’s export-oriented manufacturing sector, causing a slowdown in production, as China’s fourth quarter growth came in under 6.5%, with more slowing expected. This may encourage China to strike a deal with the US sooner than originally expected, abandoning the tit-for-tat approach they had taken throughout 2018. Unfortunately, China is not the only country impacted by these trade tensions, as the impact is being felt globally. As former Treasury Security Henry Paulson warned, this trade war could apply significant “pressure on cross-national supply chain.” For evidence of this, look no further than Apple’s negative revenue forecast revision last week, where they cited the slowdown in China resulting from the trade tensions as the primary culprit. Further, they suggested that the angst towards the US is causing a ‘Buy China’ mantra, causing Apple’s market share in China to shrink significantly. While the December dinner in Argentina during the G20 produced differing opinions on agreed upon next steps, it did delay the tariff increases on $200 billion of Chinese imports from 10% to 25% for 90 days, or until March. Undoubtedly, pressures exist for both countries to find a speedy resolution, but we believe there is still a long road ahead before we come to a comprehensive agreement.
From trade war to government shutdown, Trump’s hands are full. The fourth quarter saw mid-term elections essentially go as planned, with the Democrats taking control of the House of Representatives and the Republicans maintaining control of the Senate. A split congress has created a challenging environment to pass legislation and push the administration’s agenda. After failing to reach a budget agreement in late December, the government closed for business. Unlike some government shutdowns of the past, this closure seems to center around one topic – immigration. President Trump demands increased national security around immigration, especially as it pertains to our neighbor to the south, Mexico. He insists that a wall along the entire US-Mexico border, costing more than $5 billion, must be included as part of the budget, and that this is “non-negotiable.” The President has urged the House not push a bill to the floor unless the wall is included, and has even threatened to keep the government shutdown for “months or even years” to get his way. However, he also recently hinted that if the wall is not approved via a negotiated process, he could declare a “national emergency” and bypass congress altogether in order to build the border wall using the military. The longer the shutdown persists, the more frustrated Americans are likely to get. While we hope for a speedy resolution, signs point to an extended closure, which most likely will add to investor anxiety early in the year.
Strong out of the gate, but losing steam down the stretch?
On the back of large fiscal stimulus and tax cuts, the economy got off to a strong start in 2018. The consumer continued to drive the economy via a tight labor market, increased spending, and finally some signs of wage growth. GDP growth is expected to come in at around 3% for the year. However, as we enter 2019, many headwinds exist. Tax cuts and fiscal stimulus will still be supportive for the consumer, though at a fading rate, while corporations will look to revise guidance to more normal levels. Corporate profits grew over 25% in 2018, largely attributed to tax stimulus, so as we enter 2019, companies will be faced with the repercussions of a strengthening dollar and rising cost of credit; which will almost certainly negatively impact business investment. Inflation continues to be favorable for growth, still below the Fed’s 2% threshold. However, a full blown trade war, or even increased trade tensions and tariffs, could lead to increased inflation. Continued wage growth and an increase in oil prices could also add to inflationary pressures, potentially forcing the Fed’s hand into further rate hikes.
The Fed raised rates for the fourth time of the year in mid-December, pushing the fed funds rate to a 2.25%-2.50% range, or at the bottom of what the Fed considers its “neutral rate zone”. Prior to the December meeting, Fed Chairman Powell said we are approaching the neutral rate range – the market perceived this as the Fed saying they’re nearly at the neutral rate, so rate increases next year will be minimal, if at all. In fact, investors immediately went from predicting three hikes in 2019 to one, and the market rallied about 5% that week. Fast forward to the December meeting, and the Fed did indeed raise rates one final time for 2018, but reduced their forecast for 2019 to two hikes, striking a slightly more dovish and “data dependent” outlook moving forward. While the decision to raise rates was highly anticipated, the market was disappointed with the overall guidance the Fed provided, hoping for the removal of the potential need for “further gradual increases” and a softer tone regarding balance sheet reduction. Moving forward, transparency will be critical, as every move they make is being assessed as a potential overshoot, causing recession fears to rise.
One indication of this sentiment is an inverted yield curve, which we warned about last quarter. The yield curve plots the yield on Treasury bonds at each future maturity, and is considered a leading economic indicator. A flattening yield curve indicates that short-term rates are approaching similar levels on longer-term maturities, and typically means the longer-term macroeconomic outlook is not as positive as the shorter-term outlook. The real concern occurs, however, when a flattened yield curve turns into an inverted yield curve, where short-term rates are greater than long-term rates. Numerous studies have demonstrated a high correlation between the yield curve inverting and a recession occurring approximately 12-24 months later.
The fourth quarter saw the yield curve invert over three ranges – the 1-Year to 7-Year, the 1-Year to 10-Year, and the 2-Year to 5-Year, creating the flattest yield curve since September 2007. While those three ranges inverted, attention is given to the spread difference on the 2-Year Treasury and 10-Year Treasury (the rate on the 2-Year minus the rate on the 10-Year), which has recently approached close to 15 basis points (or 0.15%). However, recent studies conducted by the Federal Reserve Bank of San Francisco demonstrate that the spread difference between the 10-Year and 3-Month Treasury is a more accurate predictor of future economic activity, especially as it pertains to the potential predictability of a recession due to an inverted yield curve. At the end of the third quarter, this spread was sitting at approximately 85 basis points (or 0.85%). Today, that spread is currently about 23 basis points (0.23%). One could conclude the economy has a ways to run before seriously worrying about a recession in the near term, but if the Fed continues to increase rates or tighten too aggressively, this 3-Month to 10-Year spread will likely invert. It is important to note that the yield curve can, and has inverted, without leading to a recession, but there has never been a recession without an inverted yield curve. If the yield curve does invert at these more widely accepted terms (2/10 and 3month/10-Year), the market would perceive the actions of the Fed as a failure and almost certainly price in a recession. This will be something that we track very closely in coming months, as broader interest rate movements can be rapid and difficult to predict.
International Headwinds and Tension Remain – at least for the first half
Entering 2018, global markets appeared to be on the same page – experiencing synchronized solid economic growth which lead to profitable returns. Fast forward a year, and the environment has shifted. The Eurozone has struggled to maintain momentum, and while growth is still above trend, the overall tone and direction of the data has fallen off. GDP Growth and consumer sentiment have appeared to peak and roll-over, and inflation has begun to soften despite expansive monetary policy. Concerns of Italy’s unbearable debt load along with the currency crisis in Turkey dominated the headlines, dragging on equity markets and general investor optimism in the area. As previously mentioned, the strengthening dollar and trade policy uncertainty were also major headwinds for developed foreign nations. We look for these same headwinds to cause volatility and uncertainty as we enter into the first half of 2019.
We also expect Brexit to remain a factor for global markets in the new year. Prime Minister Theresa May survived a leadership challenge, but whether she can get a vote approved remains to be seen. It appears the votes are in place for a “soft Brexit”, also referred to as the ‘Norway’ option. Such a deal would give the UK Common Market access, but come with the cost of European Union (EU) membership, without any influence on regulation. In our opinion, this puts the UK in a worse position than before the Brexit vote. The UK and EU could always continue to kick the proverbial can down the road, but the more delays ensue, the more likely a second referendum vote will be forced, and the odds of “Bremain” could become a reality. Regardless of the outcome, the path from here to the final decision will be bumpy, and will likely weigh on returns.
Foreign monetary policy may shift from accommodative to restrictive, as the European Central Bank (ECB), voted in December to halt their asset purchase program. The ECB hopes to start raising rates and unwinding their accommodation by the end of 2019, but realistically, given the slowing growth and struggles in countries like Italy, we don’t anticipate the ECB raising rates until 2020 at the earliest. One of our largest concerns since the ECB began their asset purchase program was how they would unwind their balance sheet – conversely to the US that only bought government and agency bonds, the ECB purchased sovereign debt from each of its Eurozone constituents, and purchased corporate bonds. Our concern lies around how the ECB plans to unwind the corporate bond portion of their balance sheet and the impact this could have on capital markets. Given we feel we still have time before this occurs, we’re not immediately concerned, but will continue to monitor and explore this situation in greater detail. Though developed markets (rightfully) cooled in 2018 and many hurdles remain, valuations are attractive relative to the US, as they are approaching 20-year lows, yet maintaining modest earnings growth and attractive dividend yields.
Like their developed counterparts, emerging international markets have struggled through the ongoing trade dispute, and strengthening of the US dollar. However, though some economies like Turkey, Argentina, and Venezuela are in crisis mode, the major economies such as China and India are on more solid fundamental footing, and continue to post solid growth, albeit at somewhat slower levels. China’s policymakers have recently implemented numerous measures to stimulate the economy such as monetary easing, tax cuts for the middle class, and regulatory reform. Emerging market earnings are expected to rise approximately 10% in 2019, and the recent pullback in emerging market equities have created very attractive valuations. The recent fall in oil prices, should also alleviate one headwind for emerging market economies, though this may be a transient relief, as oil may continue to rise off its low levels. We would also expect that an agreement between the US and China would lead to a quick snap back in prices. Further downside risk remains, but we believe the upside scenario is more likely and merits continued exposure for more aggressive investors.
Implications for Investors
2018 proved to be a trying year for nearly every asset class – equities and fixed income alike. However, Asset Allocation strategies, designed to mitigate risk and deliver more stable long-term results, came back into favor in the fourth quarter sell-off, as the fixed income and international equity weights did not face the same decline as US market indexes. With the pullbacks equity experienced in 2018, valuations that were approaching extended level now appear relatively well-priced, or undervalued. Though we have discussed the numerous challenges in the marketplace today, we ultimately expect US equities to grind higher in 2019, based upon our feeling that corporate earnings will navigate a “soft landing” at more sustainable levels rather than entering negative territory. As previously mentioned, 2019 could bear witness to a rebound in foreign equities, though the path could remain rocky as geopolitical and trade issues are sorted out. Given this mixed outlook, we are maintaining our current portfolio exposures to both developed and emerging markets, but will remain nimble as the year progresses. As rates dropped precipitously in December, we took advantage and reduced both interest rate risk and credit risk by shortening duration in portfolios, and improving credit quality within our bond allocations. With the tightening Fed, we feel rates will reverse course and gradually rise over the course of 2019. As yields rise, we will look for opportunities to potentially extend our duration again, but for now see very little reward in longer-dated bonds given the flatness of the curve.
We understand that times of volatility can be tough to stomach for investors of all backgrounds and experience levels. It seems timely to recall Warren Buffett’s fabled advice on investing, to be “fearful when others are greedy, and greedy when others are fearful.” By maintaining a disciplined approach with a focus on diversification, we hope to provide you the confidence to keep a long-term perspective in line with your own personal risk tolerance and objectives. We appreciate your business and ongoing trust, and invite you to reach out to your advisor should you have any questions, or to schedule your next review.
Chris Osmond, CFA, CFP®
Chief Investment Officer
Eric Krause, CFA