By: Richard A. Anderson
What a difference a year makes. This time last year we were highlighting a picture-perfect year for global stocks. In 2017, both the S&P 500 and the MSCI All Country World Index ex USA were positive for all twelve calendar months. This was the first time either index accomplished this feat and it happened with near-record low volatility while enduring geopolitical tensions, political dysfunction, massive natural disasters, and tighter monetary policy. 2017 was defined by synchronized global expansion whereby most global economies were getting stronger, with the United States leading the charge.
Fast forward one year later and the narrative has changed, but the cast of characters remains the same. 2018 featured many of the same concerns that had laid the foundation of the wall of worry in 2017 (geopolitical tensions, political dysfunction, tighter monetary policy), however, investors reactions to these issues were very different.
In a widely anticipated, but highly debated, move the Federal Reserve raised the federal funds target rate following its December meeting. The unanimous decision raised the target rate 0.25%, to a range of 2.25% to 2.50%, and marked the fourth interest rate hike of the year. Additionally, the Fed pared back projections for interest rate hikes and economic growth in 2019 and beyond. In particular, the Fed expects two rate hikes in 2019, which is a reduction from the three rate hikes that had been expected following previous Fed meetings.
The Fed was in a no-win situation with its most recent decision. The Fed was under significant pressure from President Trump and stock market participants to leave interest rates unchanged. However, the Fed must remain independent in carrying out its objective to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. If the Fed didn’t raise interest rates, it would have been criticized for bowing to political pressure and letting the financial markets dictate monetary policy. So, the Fed made the decision to raise rates while indicating it will be more sensitive to economic data and consider slowing the pace of rate hikes in the future.
Amid the concerns of a full-blown trade war between the United States and China, a temporary truce was struck between President Trump and China's president Xi Jinping at the G-20 Summit in Argentina in early December. Prior to this trade truce, the U.S. had been scheduled to increase tariffs on $200 billion of Chinese goods from 10% to 25% on January 1, 2019. The agreement keeps tariffs at 10% for at least 90 days while the two sides negotiate a long-term solution. So far, the U.S. has imposed tariffs on $250 billion of Chinese imports, while China has imposed tariffs on $110 billion of U.S. imports.
While there is optimism a long-term solution to this trade disagreement between the United States and China can be reached, it has had a negative impact on many companies that are stuck in the middle. Not only are companies being hurt by higher input costs and higher selling prices due to the tariffs, but the uncertainty has meant companies are not spending as heavily on capital expenditures. Companies don't want to make huge investments in factories and production equipment if there are going to be long-term negative economic repercussions from a trade war.
While trade and interest rates were two issues that emerged earlier in the year and continued to cause volatility in the markets throughout the year, two issues re-emerged in the fourth quarter: oil prices and Brexit.
The price of crude oil, as measured by West Texas Intermediate (WTI) crude oil, declined by more than 33% from its high in early October to its low in late November. This decrease in price caused concern that oil is the proverbial canary in the coal mine signaling an economic recession is on the horizon. A decline in oil prices caused by slowing demand is seen as a precursor to a recession. However, there is debate among analysts about the cause of the price drop. Many believe too much supply, rather than slowing demand, caused the price of oil to decline. With the U.S. and Saudi Arabia producing record amounts of oil and the U.S. becoming net exporters of oil, this could certainly be the case.
The last major selloff in oil occurred in late 2015 and early 2016, which coincided with a stock market decline. The same concerns led investors to worry that a recession was imminent, however, this proved to be a false alarm.
Outside of the U.S., Brexit negotiations re-entered the global spotlight. British politicians were scheduled to vote on Prime Minister Theresa May's proposed deal for a United Kingdom exit from the European Union on December 10th. In a last-minute change of events, May announced a postponement of that vote because the deal would have been rejected by a significant margin. If that wasn't embarrassing enough, her own political party called for a vote of confidence in her leadership. May ultimately won the confidence vote, which means she is immune from a leadership challenge for one year. This vote confirms Theresa May will be the one negotiating the UK exit from the EU, and the deadline for a deal is fast approaching.
The United Kingdom will no longer be a part of the European Union at 11 PM on March 29, 2019. If there is no deal in place between the UK and EU by that date, all laws and agreements around trade, immigration, and finance would expire. This would be the worst-case scenario and one that is not expected. The most likely scenario is that May's proposed deal is modified to gain support from her own party as well the anti-Brexit crowd.
Against this economic backdrop, global stocks posted negative returns for the fourth quarter. In the U.S., large cap stocks, as measured by the Russell 1000, flirted with bear market territory, which is defined as a drawdown of 20% or greater. Ultimately, the index avoided the dreaded bear market label due to strong returns in the last four trading days of the year. U.S. small cap stocks, as measured by the Russell 2000, were not as lucky. Small cap stocks fell into bear market territory, marking the first bear market for the index since the period of June 2015 to February 2016. While small cap stocks are less sensitive to tariffs and international trade disruption, they are more sensitive to interest rates. This is because smaller companies tend to rely more heavily on borrowing to fund their operations. Smaller companies often utilize floating rate debt, in which the interest rate is adjusted periodically to reflect changes in a benchmark interest rate, rather than fixed rate debt, in which the interest rate is fixed for the duration of the loan. In a period of rising interest rates like we are experiencing, this means interest costs are rising for smaller companies, which can negatively impact their bottom line.
Outside of the U.S. in Q4, international stocks outperformed domestic stocks, but still posted negative returns. In the developed markets, Europe has remained in the spotlight, mainly due to the concerns about Brexit. In addition, there has been a divergence in policy between the United States and the rest of the world. The U.S. Central Bank, or the Federal Reserve, has been shifting to a contractionary monetary policy, raising interest rates to prevent the economy from overheating. However, the Bank of Japan and European Central Bank are still running accommodative monetary policies, such as lowering interest rates, to spur economic growth. Accommodative monetary policy should encourage greater investment in stocks, yet there is concern about long-term economic growth prospects in these countries.
Fixed income returns were positive for the quarter, providing a counterbalance to the negative returns of stocks. In the U.S., the 2-year Treasury yield closed the quarter at 2.48%, down from 2.81% at last quarter’s end. The 10-year Treasury yield closed the quarter at 2.69%, down from 3.05% at last quarter’s end. Declining bond yields are generally a positive for bond prices, as there is an inverse relationship between price and yield. As a reminder, short-term rates, like the 2-year Treasury yield, are influenced by the actions of the Federal Reserve whereas long-term rates, like the 10-year Treasury yield, are influenced by expectations of economic growth and inflation.
What we saw in 2018 is a disconnect between fundamentals and prices, particularly in the United States. The U.S. economy has grown faster than expected due to fiscal stimulus from the Tax Cuts and Jobs Act. The U.S. unemployment rate and jobless claims have been steadily declining. Plus, U.S.-based companies have strong balance sheets and have continued to beat earnings estimates throughout the year. This good news was not met with positivity from investors. Rather, it was met with volatility as stronger short-term economic growth brought tighter monetary policy from the Fed. Ultimately, stocks suffered globally because pessimistic views on policy decisions (tariffs, interest rates) outweighed the optimism of stronger U.S. economic growth.
The theme of 2018 was divergence. Divergence between fundamentals and investor sentiment. But also, divergence of U.S. growth and policy from the rest of the world. The U.S. is in the late stages of an economic expansion, which is supported by the Fed raising interest rates to prevent the economy from overheating. Internationally, many major economies are still receiving fiscal and monetary stimulus to support economic growth.
Looking ahead to 2019, the outlook remains cautiously optimistic. Quite honestly, cautiously optimistic has been a widely used phrase in our industry for the last decade. If this were a weather forecast, we would describe it as partly sunny with a chance of thunderstorms. The U.S. economy should continue to grow, but at a decelerating rate. Higher interest rates across the yield curve, a persistently strong dollar, and tighter monetary policy should slow U.S. economic growth. But that doesn't mean a recession is imminent.
The outlook for international economies, particularly emerging markets, is more optimistic. Emerging markets stock valuations continue to be the most attractive globally. A trade agreement between the U.S. and China in addition to lower growth expectations for the U.S. could be the catalyst that re-sparks the emerging markets rally we started to see in late 2016.
But what if we are wrong? What if the U.S. and countries around the world fall into an economic recession caused by one of the many issues previously mentioned? The chart below shows the performance of the S&P 500 in the twelve recessions since World War II.
As you can see from this chart, not every recession means significant losses for stocks. In the previous twelve recessions, the S&P 500 has had an average return of 1.3%, with a range of returns from 17.9% to -37.9%. This may seem surprising but it’s a reflection of our frame of reference. Our frame of reference for recessions is the most recent recession, which was the Global Financial Crisis. This time period was a major outlier and is not indicative of what to expect during a normal economic recession.
While we have painted a rosy picture for the global economy heading into the new year, this outlook is dependent on a more favorable trade environment between the U.S. and China as well as the Fed not making a policy error by raising rates too quickly. This environment should allow for the bull market to keep on running as we head into the tenth year of the U.S. economic recovery. Though, we should caution, we should continue to experience episodic periods of elevated volatility as issues of trade, Brexit, Fed policy, and politics unfold.