Equity markets came under pressure in the fourth quarter, with each of the three major U.S. stock indexes producing declines. The S&P 500® Index finished the most recent three-month period down -13.52%, the Dow Jones was down -11.31% and NASDAQ was down -17.29%. Looking at the full 12 months, each index ended 2018 in negative territory, with the S&P 500 closing the year down -4.38%, the Dow Jones down -3.48% and NASDAQ down -2.84%. Stock market volatility is a very common occurrence — in fact, the S&P 500 Index has historically averaged just 71 days between declines of 5% or more, and years in which mid-term elections have occurred have produced average drawdowns in the S&P 500 of 18%. While the sell-off in financial markets that occurred during the fourth quarter may feel unsettling, it is actually quite normal and is to be expected at the tail end of the longest bull market in history — in fact, we have been expecting it to occur for several months now.
International equities didn’t fare any better than U.S. equities. The MSCI EAFE Index, which measures equity market performance in global developed markets (excluding the U.S. and Canada), was down -12.54% for the quarter and -13.79% for the year. The MSCI Emerging Markets Index, which measures equity market performance in 24 emerging market countries, was down -7.47% for the quarter and -14.58% for the year.
Multiple factors contributed to this global downturn in equity markets. First, growth slowed across much of the globe in 2018. Although U.S. real GDP growth was solid over the past 12 months, economic growth in the Eurozone slumped to four-year lows, deleveraging and ongoing trade tensions weakened China’s once-soaring economy and several emerging market countries (Turkey, South Africa, Argentina) experienced sharp economic declines. Second, global liquidity tightened as central banks generally became less accommodative. While the Fed remains the most hawkish of the major global central banks — hikes in the Federal Funds rate and a reduction in the Fed’s balance sheet both contributed to liquidity pressures during the year — the European Central Bank began winding down its quantitative easing program in 2018 and the Bank of Japan slowed its purchases of Japanese government bonds. Third, erratic trade policy decisions from the White House prompted fears of trade wars with important trading partners. China has by far attracted the most attention from President Trump, but significant modifications were also made in 2018 to trade agreements with Mexico, Canada and South Korea, while talks are ongoing with the European Union. Protracted, public and often contentious negotiations produced much uncertainty across global markets, as trade wars can lead to increased inflation and slower economic growth.
The Bloomberg Barclays U.S. Aggregate Index, which is widely considered the proxy for the broad U.S. investment grade bond market, ended the fourth quarter up 1.64% but was flat for the year. The Bloomberg Barclays U.S. High Yield — Corporate Index, representing U.S. non-investment grade bonds, was down -4.53% for the quarter and -2.08% for the year. While U.S. 10-year Treasury yields rose slightly for the year, equity market volatility and mounting risk aversion caused yields to fall to 11-month lows to end the fourth quarter. Oil prices fell nearly 40% during the quarter, with WTI crude oil futures closing the month of December at a little over $45 per barrel. For the year, WTI crude oil futures were down approximately 25% as apprehension about slowing global growth and excess global supply battered the commodity.
At the risk of sounding like a broken record, tariffs and trade policy remained in the spotlight throughout the fourth quarter. In early December, China and the U.S. reached a 90-day ceasefire in their escalating trade war. As part of the temporary accord, China pledged to resume soybean purchases from U.S. farmers and the U.S. agreed not to increase tariffs from 10% to 25% on $200 billion worth of Chinese goods. While this deal allows some breathing room for negotiations on a longer-term trade agreement, it is not a clear sign that tensions between the two countries are thawing. If middle ground is not found within the allotted 90-day window, trade concerns could intensify quickly. As fears of a trade war with China continue to ebb and flow, demonstrable progress was made with several key U.S. allies during the quarter. In late November, leaders of the U.S., Mexico and Canada signed the U.S.-Mexico-Canada Agreement, a new trade pact that replaces the 25-year old North American Free Trade Agreement (NAFTA).
U.S. unemployment continued to generate positive headlines during the quarter, as jobs were added to the U.S. economy in each of October, November and December, extending the streak of job growth to a record 99 straight months. The unemployment rate remained unchanged at 3.7% in October and November, increasing to 3.9% in December due to growth in the labor force. Wage growth finally eclipsed the 3% annualized level during the fourth quarter, hitting 3.1% in both October and November and 3.2% in December — its best year-over-year increase since April 2009. U.S. GDP growth was also solid over the past 12 months, increasing at an annualized rate of 2.2% in the first quarter, 4.2% in the second quarter (the highest in nearly four years), 3.4% in the third quarter and an estimated 2.6% in the fourth quarter. Despite this, inflation remained firmly in check for most of the year, surprising many who expected strong economic growth to fuel price increases.
As expected, the Fed raised the Fed Funds rate at its December meeting, increasing it by 0.25% to a new target of 2.25% to 2.50%. This was the fourth increase in 2018 and ninth since December 2015. With the Fed Funds rate now approaching the assumed neutral rate, many pundits are calling for a pause in the Fed’s rate hike cycle. While Fed officials have been noncommittal — Fed chairman Powell stated that there is “no preset policy path” and that policy decisions will be made based on prevailing economic and financial conditions — the Fed did reduce its forward projections, decreasing the anticipated number of rate hikes in 2019 from three to two. Despite the indication of a more data-dependent and flexible approach going forward, stocks sold off in December because investors were hoping for more definitive comments on the potential for a rate hike pause next year. When considering Fed policy, it is important to remember that the central bank operates under a dual mandate of price stability (as measured by Core CPI) and full employment. In light of this mandate, conditions in the fourth quarter — very low unemployment and wage data that finally appears to be strengthening — warranted continued tightening to prevent the economy from overheating.
As we’ve previously stated on several occasions, our outlook over the next 12 months remains one of caution — U.S. equities are demonstrating clear signs of late cycle behavior, volatility is increasing and investor risk appetite is beginning to fall. Moreover, the potential for a recession over the next 12–24 months has likely increased. Looking toward 2019, we believe three key market risks exist: (1) slowing economic and earnings growth, both in the U.S. and around the world; (2) Fed policy, as each rate hike increases fear of a Fed mistake (raising rates too much or too quickly); and (3) politics, with a divided government likely hindering President Trump’s ability to pass legislation and intensifying talk of impeachment proceedings. With growing uncertainty across global financial markets, investors should avoid overreacting and stick with their long-term asset allocation strategy. Active investors who believe they have too much equity exposure relative to their risk tolerance and long-term objectives may want to consider whether it makes sense to de-risk into less-volatile asset classes — however, this should be done in an attempt to better align asset allocation with investor goals, not in an attempt to “time the market.” During times of uncertainty, it is important for investors to be appropriately diversified and remain committed to their long-term investing strategy. As always, we do not recommend knee-jerk decision making.
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