Quarterly Economic Review: Fourth Quarter 2018
Virtually all asset classes generated negative returns in 2018. Many investments experienced the worst drawdowns since the financial crisis ten years ago. For much of the year, global stock markets and other risk assets seemed out of step with fundamentals as economic growth and corporate earnings remained strong. Only the U.S. stock market, propelled by 25% earnings gains and perceived stability versus Europe and emerging countries, rallied. By year end, global stock markets seemed prescient as signs of a global slowdown emerged and reported corporate earnings painted a mixed picture of the business environment.
Although the rise in stock market volatility concerned investors, the magnitude of recent swings in stock prices is not unusual historically. Given the wide range of potential market shocks–rising interest rates, trade wars, political unrest, tumbling corporate earnings, stressed liquidity–spikes in volatility should be expected in the months ahead.
Even as the stock markets fell, rising interest rates and historically low yields created a dismal environment for fixed income investors. For much of the year credit risk was rewarded with high yield and emerging market debt posting the highest returns. The fortunes of the riskier segments of the bond market abruptly reversed course in December. Assets flowed out of funds focused on bank loans and high yield debt that had attracted investors seeking higher yields. Most fixed income sectors have experienced growing debt and higher leverage. One other indicator of credit deterioration is the substantial increase in high yield bond default rates.
In 2018, the U.S. Dollar reversed course as higher interest rates and strong relative growth drove the Dollar higher versus other currencies. Going forward, the large fiscal and trade deficits and a slower pace of rate hikes may be a headwind for the U.S. Dollar.
The volatility that rocked the stock markets in 2018 has magnified the opportunity to exploit valuation imbalances. The dominance of large cap growth stocks over value and smaller stocks has been exceptional. Emerging stock markets are also undervalued versus their historical average as well as other regions.
Investors that diversified across defensive and growth assets were well positioned in 2018. During periods of market euphoria, high flying technology and energy stocks generated stellar gains. During market declines, high quality bonds and alternative strategies put a floor on portfolio losses. Diversification, in conjunction with a long-term focus, is the best way to pursue investment objectives.
Key Economic Fundamentals
Fiscal stimulus from tax cuts and higher government spending prompted an uptick in U.S. economic growth in 2018. 3Q U.S. GDP growth was a healthy 3.4%, driven by consumer spending and inventories. The Atlanta Fed’s latest “GDPNow” estimate for 4Q growth is 2.7%. Although a flatter yield curve triggered recession fears, most signs point to a modest slowdown in 2019.
Economic data relative to expectations was disappointing in the U.S. and developed countries overall. The emerging markets and Europe, two regions hardest hit by negative sentiment in 2018, defied the downward trend with results surprising on the upside. Strong stock market returns tend to follow unexpectedly favorable economic results.
After an anemic start, consumer spending rebounded to drive solid economic growth in 2018. Expanding inventories propelled investment spending in the face of slowing housing and weak business spending. U.S. businesses accelerated export shipments in 2Q, fearing retaliatory tariffs from China. Following the resultant sharp drop in 3Q, net exports are expected to rebound.
Leading economic indicators (LEI), designed to identify inflection points in economic growth, declined for most countries in 2018. The deterioration in many large economies such as the U.S. and Japan, was modest. China’s LEI seems to have stabilized. India, which has strong support from government spending, was the only country with a materially positive LEI. European countries, notably those in Eastern Europe, have the weakest prospects.
In 2018, the U.S. Dollar rose over 7% versus a trade-weighted basket of other currencies, reversing the downtrend that prevailed the prior year. Emerging currencies were volatile as rising U.S. interest rates bolstered the Dollar. The worst performing currencies, the Argentine Peso and the Turkish Lira, also faced country specific turmoil. The Chinese Renminbi declined 5% as the trade war raged. The Euro stabilized after weakening materially over Brexit concerns and Italy’s fiscal problems.
Global growth forecasts for developed countries moderated after disappointing results in Europe and Japan earlier in the year and the onset of trade tensions between the U.S. and China. In the U.S., the stimulus from tax reform is expected to wane. Emerging countries such as China and India have the highest potential for robust growth rates. Energy exporters such as Russia have benefited from a rebound in energy prices. Policy risks are high, calling for a cautious outlook for global growth.
The U.S. labor market continued to be a pillar of strength for the domestic economy. Jobs were created at a strong pace relative to history for much of 2018. In November, private payroll growth missed consensus expectations and showed signs of slowing, but sharply rebounded with a gain of over 300,000 jobs in December. U.S. employment has now surpassed 150 million jobs for the first time. The number of people receiving unemployment claims is lower than it has been in the past 45 years. The unemployment rate, after dropping to a new cycle low of 3.7% in September, rose to 3.9% at year-end but remains at the lowest level since the 1960s. Average hourly earnings picked up as the year progressed, reaching 3.2% in November. Skilled workers are in short supply in several industries. The Federal Reserve will be closely watching for signs of wage inflation when setting interest rate policy over the coming year.
U.S. consumers have benefited from historically low unemployment, modestly rising wages and contained inflation. Confidence reached an 18-year high in September, before retreating when consumers became increasing worried about stock market volatility and their job prospects. Retail sales continue to paint a bright picture, up over 4% year over year. Notably strong components include the online, clothing and health care categories. Even cyclical sectors such as auto sales are not flashing warning signs. Household debt relative to U.S. economic output has declined to levels last seen in 2002. On the downside, the personal savings rate has been declining and rising student debt, lower rates of home ownership, and the prospect of higher inflation as the cost of trade tariffs flow through to prices are all risks to consumer well-being.
Both the U.S. service and manufacturing sectors continued to expand in 2018 based on the ISM indexes which use industry surveys to evaluate economic activity. Corroborating the strength seen in the ISM surveys, in September the industrial production index grew at the fastest annual pace since January of 2011. U.S. businesses benefited from tax reform enacted last year, including the reduction in the corporate tax rate from 35% to 21% and lower levies on the repatriation of overseas cash. Global manufacturing PMI has been weak with new orders, production and employment dropping sharply largely due to a slowdown in exports. China’s most recent PMI indicates that business activity has contracted despite government support. In December, the U.S. ISM manufacturing index experienced its largest drop since 2008. These markers may indicate temporary weakness, but trends in China and the U.S. bear watching.
The housing market, an important driver of consumer spending as well as employment in the U.S., lost ground in 2018. Sales activity seems to have reached a cyclical peak. Existing home sales have declined almost 7% over the past year and the supply of inventory remains lackluster. Building activity has fallen from a post-crisis high after trending lower since January and builder confidence has dropped. Home prices continue to rise overall, but at a slower pace, and some market segments have seen material price declines. There are signs that the housing market is stabilizing. The negative impact of tax-reform, particularly in high income tax states with elevated property taxes, may have been absorbed. The increase in mortgage rates as interest rates normalized has been a large factor dampening home buyer demand. Mortgage rates have recently moved lower, a welcome development that could support demand going into the Spring selling season.
Capital Markets Review
Fixed Income Markets
Disclaimers: This commentary was written by Noreen Johnston, CFA, Director of Research at Summit Financial, LLC., an SEC Registered Investment Adviser (“Summit”), headquartered at 4 Campus Drive, Parsippany, NJ 07054, Tel. 973-285-3600. It is provided for your information and guidance and is not intended as specific advice and does not constitute an offer to sell securities. Summit is an investment adviser and offers asset management and financial planning services. Indices are unmanaged and cannot be invested into directly. The Wilshire 5000 Total Market Index measures the performance of all U.S.-headquartered equity securities with readily available price data; the Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market; the MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada; the MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure the equity market performance of emerging markets; the Bloomberg Commodity Index measures the performance of an unleveraged, long-only investment in commodity futures that is broadly diversified and primarily liquidity weighted; the HFRI Fund of Funds Composite Index is an equally-weighted benchmark composed of over 400 domestic and offshore constituent funds having at least $50 million under management or having been actively trading for at least 12 months; the Bloomberg Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bonds, mortgage backed bonds, corporate bonds, and some foreign bonds traded in the U.S.; the Bloomberg Barclays Global Aggregate Ex U.S. Index measures the performance of global investment grade fixed-rate debt markets that excludes USD-dominated securities. The Bloomberg Barclays Municipal Bond Index covers the U.S. dollar-denominated long-term tax-exempt bond market. Data in this newsletter is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Consult your financial professional before making any investment decision. Past performance is no guarantee of future results. Diversification/asset allocation does not ensure a profit or guarantee against a loss. 02122019-115