Was the Fourth Quarter Really Just a Glitch?

It has been reported that 90% of asset classes suffered losses in 2018. There were few places to hide, even for well-diversified investors. As we will explain, this was an unusual outcome.

The losses were undoubtedly far reaching. In the face of a stronger U.S. dollar, international equity markets struggled. Small and mid-capitalized companies experienced especially bad losses both domestically and abroad. Domestic and global bond markets were not much help either. Continuing this theme, publicly held real estate in the form of REITS (real estate investment trusts) and even less conventional assets like commodities and precious metals produced negative annual results. The best annual performance from a major global asset class came from U.S. Treasury Bills at 1.86%. This is a historical rarity: the last time that T-Bills took first prize was in 1981 when they were up 15%.

What happened is puzzling. It is not evident that any speculative bubble burst. Nor were there any financial crises such as we experienced in 2008. If anything, 2018 should have provided a good fundamental backdrop for equity investment. Global economic growth was the strongest generated in about eight years. In the U.S. and most other developed countries, inflation is well under control. U.S. corporate earnings grew at a robust 25%.

We think the following factors contributed to the challenging year.

RISING INTEREST RATES

"...interest rates moving higher from a historically depressed level is a signal of economic and financial health, and a path towards “normalization” is desirable."

Coming into 2018, we observed that stock valuations were quite high and believed there was a strong probability that interest rates would increase, introducing volatility to global markets. In fact, the U.S. Federal Reserve Board increased the federal funds rate four times in 2018. While higher interest rates can be viewed as a deterrent to investment, they are not necessarily so. It is perfectly normal and possibly even advisable for a central bank to increase rates as the domestic economy picks up steam. Moreover, interest rates moving higher from a historically depressed level is a signal of economic and financial health, and a path towards “normalization” is desirable. Yet, twice last year (in late January and then again in the fourth quarter), equity markets reacted negatively as 10-year U.S. Treasury yields neared 3%. In both cases, as rates retreated, the S&P 500 Index eventually stabilized. It is interesting to note, however, that after the first episode at the end of January 2018, large-capitalization stocks in the U.S. resumed their climb until the fourth quarter. Other asset classes, such as domestic small and mid-capitalization stocks and international equity markets, began to roll over and never recovered from the peaks hit early in 2018.

RECESSION RISK

"As we progressed through 2018, investors began to focus on the “threat” of an inverted yield curve."

As we progressed through 2018, investors began to focus on the “threat” of an inverted yield curve. This is viewed with concern because past inverted yield curves have proven an accurate predictor of an economic recession, typically occurring within 12-24 months. Why does the yield curve invert and why has this worked as an economic indicator? An inverted yield curve occurs when short-term government interest rates are higher than long-term rates. Historically, as economic expansions begin to show signs of over-heating, the Central Bank increases interest rates to help moderate growth and the possibility of higher inflation. Eventually, higher short-term rates succeed in slowing economic growth, and this may be reflected in lower long-term rates, which anticipate the slowdown. The chart below shows long-term trends in both short (red) and long (gray) government bond yields. The yield curve is not inverted at present (the gray line is still above the red line). There have been other periods where the yield curve has been flat, such as today, and the economy did not fall into recession.

POLITICAL ANGST

Reflecting uncertainty surrounding the current political climate, market volatility spiked at the conclusion of the November 2018 U.S. election cycle. Normally, the markets favor gridlock in Washington as it has the potential to reduce the range of outcomes, lessening uncertainty. It is possible that investors began to look forward to the next election cycle and did not like what they envisioned.

SLOWING GLOBAL ECONOMIC GROWTH

Coming into 2018, investors were generally optimistic about economic conditions and signs pointed to the continuation of a synchronized global economic upswing. However, as the year progressed, evidence began to accumulate that global economic growth is slowing. The explanations for the slowdown were higher interest rates, a stronger U.S. Dollar, growing pains in China, increasing trade-related roadblocks, less stable political conditions, and the record length of the economic cycle itself. In the U.S., economic conditions remained more robust than those of most of our major trading partners. Still, increased interest rates may have negatively impacted certain parts of our economy such as housing and auto sales. During the summer months, there was talk about an over-heating economy and the potential for seriously higher levels of price inflation. By the time the year ended, the narrative had changed to economic recession as the foremost risk.

SLUMP IN OIL PRICES

This distinctive reversal of fortunes was no more apparent than in the oil markets. The negative price action in the oil markets during the fourth quarter of 2018 was unprecedented. Oil prices peaked in September and declined virtually every day for two months straight. We believe that the dramatic nature of this reversal caught many investors off guard and served to reinforce the new narrative of a possible recession.

Ultimately, it may be said that expectations were too high coming into 2018, with prices in the stock market reflecting near perfect conditions of growth and stability. Circumstances last year were set up for negative surprises—and they arrived as the year progressed and were reflected in prices in the fourth quarter. However, coming into 2019, expectations appear realistic and maybe even overly pessimistic.

LOW RISK OF RECESSION

"We do not see the probability of a recession as high at this point. We expect the U.S. economy to grow at a healthy, albeit slower pace in 2019 and probably 2020 as well."

We do not see the probability of a recession as high at this point. We expect the U.S. economy to grow at a healthy, albeit slower pace in 2019 and probably 2020 as well. Due to the very tight labor markets domestically, we anticipate that wage inflation will continue to climb over the next few years as the benefits of the stronger economy are more broadly shared within the populace. The general level of inflation could also trend higher once we get past the effects of the recent abrupt decline in oil prices. Additionally, price inflation could be stoked by persisting trade tensions and any tariffs that might come about.

CONTINUING ROLE OF INTEREST RATES

While the slowing pace of global economic growth may diminish the chance of materially higher interest rates, we expect the direction will remain toward higher rates in 2019, and, consequently, continued market volatility. One reason for our negative view is that the supply of bonds should increase materially in 2019.

"While the slowing pace of global economic growth may diminish the chance of materially higher interest rates, we expect the direction will remain toward higher rates in 2019, and, consequently, continued market volatility."

The U.S. Treasury is expected to issue a record amount of bonds this year, with more Treasury bonds being issued as a percent of GDP than at any point since World War II. On top of this, unlike 2018, this year will see a large amount of corporate bonds maturing, leading to more issuance. Television character Gomer Pyle used to say, “Surprise! Surprise! Surprise!” This year, there should be no surprise that fixed income markets will need to deal with supply, supply, and more supply. Borrowers will need to entice global investors with higher yields for this surplus of debt. The large Treasury issuance has the potential to “crowd out” other markets, causing concerns about global liquidity.

Interestingly, the futures markets are pricing in zero U.S. Central Bank interest rate increases this year and a rate cut for next year. The Central Bank, while backing off its stricter rhetoric, still indicates two bumps in rates for 2019. Given moderate U.S. economic growth, one to two more rate increases seems appropriate to us.

The low level of interest rates for the last decade has been a mammoth tailwind for investors in stocks and other risky assets. In the U.S., the tailwind has ceased for now. This does not mean that a bear market is imminent, but it could lead to choppier markets. As the chart above displays, both short- and long-term rates were headed higher in the 1998-2000 period, and all the while, as we recall, the stock market exploded higher. Valuations on stocks have declined significantly from this time last year and the opportunity set for our clients is therefore much improved. President Trump described the stock market pullback in the fourth quarter as a “glitch.” If the glitchy oil market is any indication, the recent +15% rebound in prices points toward growth in demand for that resource and fair economic growth ahead.

KEEP AN EYE ON CORPORATE EARNINGS

"Without the tailwind of low interest rates, corporate earnings will be a more important contributor to stock returns." 

Without the tailwind of low interest rates, corporate earnings will be a more important contributor to stock returns. Corporate earnings are expected to grow nicely (5% to 6%) in 2019 after a record year in 2018. So far in 2019, earnings reports support these growth expectations. However, if this growth does come about as estimated, corporate profits will be at their highest level relative to GDP in modern history, which may not be sustainable for long.

"Tax cuts, low interest rates, and depressed wages have supported today’s higher profit margins. Over time, these contributors will likely revert to normal levels."

While the chance of a market drop due to high valuations has decreased, we will need to be careful about the prices paid for stocks. Tax cuts, low interest rates, and depressed wages have supported today’s higher profit margins. Over time, these contributors will likely revert to normal levels. Market conditions such as we have described should be conducive to long-term oriented investors. We believe our focus on profitable franchises and strong balance sheets should help preserve capital in volatile markets while our careful approach to investment and prices paid should improve our chances for superior returns over the long run.

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The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.