January 9, 2019. By Mark Barry:
Despite strong US economic growth and a favorable environment for corporate America, the majority of asset classes struggled to deliver positive total returns for investors in 2018. While the year started off on the right foot, bearish sentiment dominated toward the end, with December being one of the worst on record for the US equity markets. The S&P 500, Nasdaq Composite, and Russell 2000 indexes all dipped into bear market territory, defined as a 20% drawdown from their 52-week highs. And while fixed income fared better, the 0.01% return on the Barclays Aggregate Bond Index for the year wasn’t much for investors to cheer about. As the quilt chart below illustrates, almost every major asset class finished down for the year, with cash being the best performing asset.
Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management.
Following the December correction, the past two weeks have seen markets rebound off their lows, but volatility has remained elevated. As we move into 2019 we wanted to share our thoughts on what is behind the recent drawdown, and how this may affect markets going forward.
Markets were buffeted by a long list of negative headlines in the fourth quarter, however we view the December market correction as driven primarily by three broad issues:
- US-China Trade Tensions
- Global Growth Concerns
- FOMC Meeting / Rate Hikes
US-China Trade Tensions
The back-and-forth between the US and China on trade and tariffs loomed over markets for the entirety of 2018, with the main concern being the potential for the spat to escalate into a full-blown trade war. While it was a rollercoaster ride, with periods of both fear and optimism regarding the prospects for a deal, it appears that some progress has been made; the US recently declared a 3-month hiatus on additional tariffs while formal trade talks continue, and the Chinese have resumed imports of LNG and soybeans from the US. It remains to be seen if the two sides will be able to come to an agreement by March 1st (when additional US tariffs are slated to kick in) but there is certainly economic incentive for both the US and China to do so. Economic damage so far has been limited and we haven’t seen the effects feed into corporate earnings, but should the situation devolve further the damage could negatively impact the financial markets.
Global Growth Concerns
The markets became increasingly concerned with the pace of global economic growth towards the close of the year, which put pressure on both equity and credit markets. While economic data in the US was largely positive, growth is likely to moderate as the impact of fiscal stimulus fades, and the US moves into late-cycle. Exactly how much longer the current economic expansion will last for the US has been subject to debate, but what really concerned markets was that with the US expected to slow, it appeared that the rest of the world economy was decelerating as well. There was disappointing industrial output and retail sales data out of China, while in Europe economic indicators pointed to a slowdown which is likely to be compounded further by political tensions associated with Brexit, protests in France, and conflict between Italy’s government and the EU over the budgetary process. These all continue to be valid concerns for markets, although they may have been overexaggerated in the short-term.
FOMC Meeting / Rate Hikes
The Fed continued its gradual pace of monetary tightening in December, announcing a 0.25% increase in the Federal Funds rate to a range of 2.25% – 2.50%. This rate hike was expected and was largely priced into the markets. However, because of the volatility in asset prices and the aforementioned concerns about global economic growth, the markets wanted to see the FOMC and Chairman Jerome Powell signal that a pause in rate hikes was likely. When this failed to materialize in the FOMC statement and press conference, leaving additional rate hikes on the table, the markets sold off. The concern is that the Fed risks overtightening policy which would push the economy into recession – this has happened in the past and certainly could again. But the market reaction may be a little overdone, as the Fed appears to be hiking rates for the right reasons, i.e. strong economic growth with the potential for higher inflation.
Since the last week of 2018 the equity markets have rebounded, and while the above three issues remain as risks, it appears that the markets were exaggerating them at least in the short-term. As we move into 2019, the big question for investors is whether this drawdown is a healthy reset/correction as it was in mid-2011 or late-2015 and the secular bull market in equities will continue, or is this the start of something more.
From an economic perspective, while the business cycle is likely in its latter stages with a tight labor market, a flattening yield curve, and a pickup in market volatility, the US economy is still fundamentally strong and should support continued expansion. A recession will happen eventually (as it is part of a normal business cycle) and the risk of one continues to increase, but the most recent release of the LEI (Leading Economic Indicators) Index and associated economic data suggests there is not a high probability of one in 2019. That said, it appears that the US could have a few more years of growth ahead.
Looking at the capital markets, despite the recent correction, we see some positives for investors. First, with the selloff in equities, valuations have become more attractive as the S&P 500 now trades around 15x 2019 forward earnings. There is the risk that these earnings fail to materialize and/or rising interest rates constrain multiple expansion, but as the chart below demonstrates US equity valuations have become more attractive than earlier in 2018.
Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management.
Second, although rising rates caused bond prices to fall in 2018, the corresponding increase in yields means that investors can now earn a reasonable return on fixed income, particularly on the short end of the curve with 2-year US Treasury yields exceeding 2.50%. And while concerns about corporate leverage remain, spread widening on lower demand for corporate credit has made corporate bond valuations more attractive. In both cases, fixed income yields should provide a little more cushion for investors in equity market drawdowns while allowing them to earn positive real returns should interest rates remain subdued.
We would remind investors that while equity and fixed income valuations have become more attractive, market volatility will likely remain elevated as the US economy moves into the latter stage of the business cycle. It is essential for investors to avoid being reactionary to market swings and to take a long-term approach to their investment portfolio. To do this we encourage investors to meet with their advisors and have a clear long-term plan which addresses their overall asset allocation, return objectives and risk tolerance. Only by having a clear plan of action before entering a storm will investors have the ability to sail through it with confidence. As always, we encourage you to reach out with questions or to schedule a time to talk about your portfolio, and we look forward to updating you further on in 2019.