Investors’ appetite for risk, while elevated for much of 2018, evaporated as the year drew to a close and wiped out positive returns for the year across broad asset classes (T-bills being a notable exception). Concerns over tighter monetary policy and the global withdrawal of stimulus measures, unresolved trade disputes, falling oil prices, slower global growth, and softer data in some U.S. indicators overshadowed other robust aspects of the domestic economy. U.S. Treasury prices rose, expectations for Fed hikes in 2019 dissipated, and the S&P 500 had its worst December since 1931. Market sentiment clearly reflected the “glass half empty” viewpoint, with the S&P 500 at one point falling nearly 20% from a record level hit only a few months earlier. Meanwhile, the “safe haven” status of U.S. Treasuries attracted investors and pushed yields lower—the yield of the 10-year Treasury dropped 55 bps from a multi-year high of 3.24% reached in early November to close the year at 2.69%.
Those who espouse a “glass half full” viewpoint point to a number of economic data points in the U.S. to support their view. The unemployment rate remained near a 50-year low at 3.7%, and wages have been growing. As of Nov. 30, average hourly earnings were up 3.2% year-over-year, the most since April 2009. Consumer confidence remains elevated, though measures of future expectations have recently begun to turn downward. Similarly, small businesses continue to be optimistic; the NFIB Small Business Survey remains significantly above its average. And early data suggests that holiday sales were the strongest in six years, according to Mastercard SpendingPulse, which tracks both online and in-store sales. While the consensus for 2019 GDP is down from the 3.4% rate registered in the 3rd quarter, the estimate among Federal Reserve officials for 2019 is 2.3%, far short of a recession.
At the same time, shadows have emerged in certain sectors and dampened enthusiasm for 2019 prospects. Thus, those with a “glass half empty” viewpoint harbor worries over tightening monetary policy, the global impact of trade tariffs, and falling oil prices. Specifically, December data revealed a weakening manufacturing picture—the Federal Reserve Bank of Richmond’s monthly manufacturing survey unexpectedly fell sharply and marked the fourth district bank factory survey to drop in December. The impact of tariffs has been widely cited as the key driver of weakness in manufacturing. The housing market also appears to have softened. Pending home sales fell to a four-year low as rising mortgage rates and relatively high prices deterred buyers, and spending on building and improvements has also weakened.
Inflation remained benign. The CPI was up 2.2% in November (year-over-year) for both the headline and core statistic. While energy prices are up over the last 12 months, recent declines will be reflected in inflation measures in coming months. The Fed’s preferred inflation gauge, the PCE Deflator, rose 1.8%
over the trailing year. As widely expected and in spite of political pressure aiming to curb rate hikes, the Federal Open Market Committee (FOMC) voted unanimously to increase its federal funds rate target by 25 bps, bringing it to 2.25%–2.50%. The Fed further indicated that “risks to the economic outlook are roughly balanced,” providing no help to the “half full vs half empty” debate. That said, investors took a much more gloomy view – the year-end read of fed funds futures prices indicated a nearly 90% probability of no Fed hikes in 2019, a view that has shifted sharply from just two months ago when futures signaled a 90% likelihood of at least one hike in 2019. The FOMC also reduced its projections for 2019 rate hikes from three to two.
News from overseas also contributed to investors’ slate of worries. Uncertainty over the details of a Brexit deal (or lack thereof), the magnitude of the slowdown in China, and numerous geopolitical worries weighed on markets. The UK faces the prospect of a “no deal” Brexit in March, an event that would likely have severe repercussions for the country. Political and fiscal turmoil in Italy, protests in France, and withdrawal of stimulus measures also weighed on markets. The European Central Bank confirmed that it would discontinue its monthly bond purchases at the end of December 2018 but will continue to reinvest maturities. Euro zone GDP rose just 0.2% in the 3rd quarter (+1.6% year-over-year). Meanwhile, the Japanese economy contracted 0.6% in the 3rd quarter (-2.5% annualized), the most in over four years. Japan was hurt by several natural disasters as well as a decline in exports. China’s 3Q GDP post was +1.6% (+6.5% year-over-year), but the impact of trade tariffs appears to be taking a toll; its manufacturing index fell below 50, a level that signals a contraction, and retail sales in November grew at the slowest pace in 15 years.
The 4th quarter saw volatility return with a vengeance, especially in December. The S&P 500 gained/lost more than 1% in a day 10 times in December alone; in the entire year of 2017 this occurred only eight times. The Index fell nearly 20% from its high in only 11 weeks and the VIX closed the year at 25.4, up sharply from prior years but only modestly above the average over the past 12 years. While the economic worries mentioned above played a role, a government shutdown, continued trade rhetoric, and broad-based risk aversion also fueled the sell-off.
For the quarter, the S&P 500 Index fell 13.5%, its worst quarterly result since 3Q2011 and more than erasing its gains for the year (2018: -4.4%). Small cap stocks suffered the most (R2000: -20.2% vs R1000: -13.8%) during the quarter and also underperformed for the full year (R2000: -11.0% vs R1000: -4.8%). Growth stocks also fared the worst in 4Q (R1000 Growth: -15.9%; R1000 Value: -11.7%) but did best for the full year (R1000 Growth: -1.5% vs R1000 Value: -8.3%). From a sector perspective, falling oil prices pummeled Energy stocks (-23.8%), the worst sector by a wide margin, while Utilities (+1.4%) was the only sector to produce a positive quarterly result.
Non-U.S. developed markets were down in a similar fashion over the quarter. The MSCI ACWI ex-US lost 11.5%, with most countries posting losses. For the full year, the non-U.S. developed equity markets trailed the U.S. by a significant margin; the ACWI ex-US fell 14.2% and not one of the constituents posted a positive return for the year in U.S. dollar terms. Emerging market performance was mixed; while the MSCI EM Index lost 7.5% during the quarter, a number of countries did well. Brazil (+13.4%), Turkey (+4.8%), and India (+2.5%) fell into that category. Mexico (-18.8%) was the worst performer, and China (-10.7%) and Russia (-9.0%) also underperformed the broad Index. For the full year, the MSCI EM Index (-14.6%) trailed the developed markets by only a small margin. Again, results were mixed with Turkey (-41.4%) on one end and Russia (-0.7%) on the other.
Fixed Income Markets
Global fixed income benefited from a tumultuous equity market and concerns over slowing growth. In the U.S., the Bloomberg Barclays US Aggregate Bond rose 1.6% for the quarter, with U.S. Treasuries (Bloomberg Barclays US Treasury: +2.6%) leading the pack. The 10-year U.S. Treasury yield closed the quarter at 2.69%, down sharply from the multi-year high of 3.24% hit in early November. Portions of the yield curve inverted, but the widely watched spread between the 2- and 10-year Treasury note remained positive at 21 bps. TIPS (Bloomberg Barclays US TIPS: -0.4%) sharply underperformed nominal Treasuries on diminished expectations for inflation. Investment grade corporates (Bloomberg Barclays Corporate: -0.2%) underperformed in spite of muted supply as risk appetite faded and worries mounted over rising corporate leverage. Investment grade spreads widened to levels (+153 bps) not seen since July 2016. The high yield corporate bond market (Bloomberg Barclays High Yield: -4.5%) was also down sharply as demand and liquidity evaporated against the volatile equity backdrop. For the first time in 10 years, there was no high yield bond supply for the month of December. High yield corporates underperformed Treasuries by nearly 700 bps for the quarter as the sector’s average yield-to-worst approached 8%. Leveraged loans did not escape the carnage and sank 3.5% (S&P LSTA) for the quarter as the sector saw record outflows. Municipal bonds (Bloomberg Barclays Municipal Bond +1.7%) fared reasonably well but could not keep pace with U.S. Treasuries. For the year, the Index rose 1.3%.
Overseas, yields also generally fell but U.S. dollar strength detracted from unhedged non-U.S. returns. The Global Aggregate Index rose 1.2% for the quarter on an unhedged basis and was up 1.7% hedged. The dollar appreciated vs most currencies during the quarter, with the notable exception being the yen. Emerging market debt was a relatively bright spot given the risk-off environment. Local currency emerging market debt, as measured by the JPM GBI-EM Global Diversified Index, gained 2.1%, with notable outperformers being Turkey (+29.8%), Argentina (+16.7%), and Brazil (+11.4%). The U.S. dollar-denominated JPM EMBI Global Diversified Index fell 1.3%, with performance mixed across its 60+ countries.
With the exception of gold (S&P Gold Spot Price Index: +7.1%), liquid real asset investors found few places to hide during the quarter. Commodities indices were off sharply. The Bloomberg Commodity Index lost 9.4% and the S&P GSCI Commodity Index plunged 22.9%; the deviation between the two indices was largely attributable to the plummeting price of oil (down 40% and a much larger allocation within the S&P GSCI Index) from a 4-year peak of $76/barrel in October to close at $45/barrel on concerns over both supply and waning demand. Meanwhile, MLPs could not avoid the knock-on effects of lower oil prices (Alerian MLP Index: -17.3%); REITs were down 6-7% abroad and in the U.S., and the DJ-Brookfield Infrastructure Index suffered a decline of 6%. TIPS also delivered a negative return as the 10-year breakeven spread narrowed to 1.71% from 2.14% as of 9/30 on reduced expectations for inflation.
Recent volatility is not remarkable from a historical standpoint and could well be a harbinger of 2019 market performance given a wide array of economic, political, and market-related scenarios that are currently vexing investors. That said, 2018 was an unusual year where virtually all asset classes posted negative returns and one that is unlikely to be repeated in 2019. As we have stated in the past, adherence to an appropriate and well-defined asset allocation (including periodic rebalancing!) remains the best course of action to manage the path to successful attainment of long term investment goals.