January 11, 2019

Market Summary – Year-End 2018

What a difference a year makes.  Remember that 2017 was a year of synchronized global growth which resulted in upbeat investor sentiment, strong positive returns, and low volatility.  For example, the S&P 500 index had a positive return in each month of 2017 and gained almost 22% for the year.  Contrast that to 2018 when volatility in financial markets returned in earnest and investor sentiment shifted to become more skeptical as economic activity diverged with the U.S. accelerating and other countries slowing, trade tensions flared, and the Federal Reserve and certain other central banks tightened monetary policy.  The result was a roller coaster ride for asset prices with negative calendar year returns almost across the board by asset class and geographic region.

 

Market Index Returns – 2018

The volatility and weakened sentiment occurred despite solid fundamentals in the U.S.  Economic activity was strong.  For example, gross domestic product (GDP) growth was 2.2% for the first quarter, 4.2% for the second quarter, and 3.4% for the third quarter.  The unemployment rate fell to 3.7% in November, a 49-year low, from 4.1% in January.  The number of job openings hit an all-time high of 7.3 million in August and continues to be about 1 million more than the number of unemployed people in the U.S.  The Purchasing Managers’ Indices (PMI) of manufacturing and non-manufacturing activity reached multi-year highs.  Retail sales were the best in years.  Holiday season sales were up over 5% according to MasterCard.  Corporate profits were very strong in 2018.  Earnings for the S&P 500 index companies grew about 25% in each of the first three quarters of the year.  The 2017 Tax Cuts and Jobs Act that went into effect in 2018 provided a significant boost to earnings, but revenue growth was also strong throughout the year.

The robust economic data reports continued throughout the year despite the U.S. dollar strengthening and the imposition of various trade tariffs on a variety of products from many countries, most notably China.  The tariff activity for the year started with tariffs on imported solar panels and washing machines.  Next came import tariffs of 25% on steel and 10% on aluminum from Canada, Mexico, the European Union, South Korea, and others on national security grounds.  Tariffs on Chinese goods increased significantly in the second half of the year.  In July, tariffs on $34 billion of Chinese goods were implemented.  In August, tariffs on an additional $15 billion of Chinese goods were enacted.  In September, a 10% tariff was imposed on an additional $200 billion of Chinese goods with the tariff set to increase to 25% if the U.S. and China do not come to an agreement by March 2019.  Most countries retaliated in a tit-for-tat manner with tariffs and restrictions against the U.S.  U.S. agriculture products and iconic brands were the primary targets.

The tariffs had a slowing impact outside the U.S., particularly on China and Germany.  China’s economy slowed for internal reason as well, such as the government’s attempt to rein in credit.  As China slowed countries heavily involved in the supply chain into China also slowed.  Manufacturing data reflected the slowdown.  China’s manufacturing PMI went from 51.5 in January to 49.7 in December (A number under 50 indicates contraction).  Germany’s manufacturing PMI went from 61 in January to 51.6 in December, a five-year low.  Germany and Japan even had negative GDP growth during the year.  Germany’s third quarter GDP growth was -0.2% on a quarterly basis and Japan had negative GDP growth of -1.3% in the first quarter and -2.5% in the third quarter on an annualized basis.

Worries about a slowdown in the U.S. were fueled not only by trade tensions but also by Federal Reserve Open Market Committee (FOMC) actions.  The FOMC raised the target range for its federal funds rate by 0.25% four times in 2018.  The last increase was in December to a range of 2.25% to 2.50%.  The FOMC consistently indicated throughout the year its intent to gradually raise rates dependent on economic data.  The latest FOMC projections indicate two rate hikes in 2019, which was down from three hikes previously projected.  The FOMC also reduced the amount of bonds held on its balance sheet throughout the year, which also worked to tighten monetary conditions.  As the year went on, market participants became increasingly worried that the FOMC was tightening too much and was increasing the risk of choking off economic growth which ignited risk aversion sentiment and fueled an equity market sell-off.  The higher interest rates and better economic growth in the U.S. than in many other regions pushed the U.S. dollar higher against a number of currencies, which pressured many emerging markets.

The negative calendar year returns for major equity indices disguise the fact that 2018 was a record setting year in U.S. equity markets.  The S&P 500 set 19 new highs during the year with the first in January and the last in September.  The Russell 2000 set 30 new highs.  However, the peak periods were followed by sharp sell-offs.  The S&P 500 fell 10.2% from the January peak to the February low and declined 19.8% from the September high to the December low.  The Russell 2000 entered a bear market with a decline of over 20% from its August peak to the December low.  As a reminder, the S&P 500’s largest decline in 2017 was only -3% and before 2018 the index had not had a correction (decline of 10-20%) since February 2016.  Large intraday swings were also common in 2018.  Growth stocks outperformed value stocks in each of the market capitalization (cap) categories.  Growth outperformed despite the utilities sector, which is typically considered a value sector, posting the best returns for the year in the mid and small-cap indices and the second best return in the large-cap index.  The healthcare sector had the highest return in the large-cap index.  The information technology sector was another top performing sector for the year across the market cap spectrum.  The value indices were pulled down by the significant declines in the energy and materials sectors, which had the lowest returns in the large, mid, and small-cap indices.

International equity indices posted double-digit negative returns for 2018 and underperformed U.S. equities.  Currency was a drag on returns from foreign stocks for U.S. investors since the U.S. dollar strengthened against many currencies.  The MSCI EAFE index of developed international stocks had a return of -13.8% and the MSCI Emerging Markets (EM) index had a return of -14.6% on a U.S. dollar basis.  The EAFE and EM returns on a local currency basis were -11.0% and -10.16% respectively.  Growth stocks outperformed value stocks in the developed market index.  The healthcare sector provided a boost to the growth index while weakness in the financials sector was a drag on the value index.  In the EM index value stocks outperformed growth.  Healthcare and consumer discretionary stocks were particularly weak in emerging markets while the value sectors of energy and utilities were the best performing.  On a geographic basis, among developed international regions, the Pacific ex Japan region outperformed both Europe and the Far East.  New Zealand and Israel were among the best performing developed countries while Germany and Ireland were the weakest performers.  Among emerging market countries, Latin America outperformed emerging Europe and China.  Brazil and Russia were two of the best performing EM countries while China and South Korea were two of the weakest.

The main story in the fixed income market for the year was the flattening of the Treasury yield curve as short maturity bond yields rose throughout the year in response to the FOMC’s four interest rate hikes and strong economic activity while longer maturity bonds rose less.  The yield on three-month Treasury bills increased steadily to end the year at 2.45% after starting the year at 1.39%.  The two-year Treasury bond yield, which started the year at 1.89% got as high as 2.98% in November, which was the highest level since 2008.  The two-year bond yield declined again in December on safe haven trading during the sharp equity sell-off and ended the year at 2.48%.  The 10-year Treasury bond yield reached 3.26% in October, which was the highest yield since July 2011.  The 10-year also declined during the equity market sell-off and ended the year at 2.69%, which was still higher than the 2.40% yield at the start of the year.  Fixed income sector returns were mixed.  Longer maturity bonds underperformed shorter maturity bonds in the rising interest rate environment.  Treasury bonds outperformed corporate bonds as the spread between the yield on Treasury bonds and corporate bonds widened from multi-year lows on increasing concerns about corporate earnings growth decelerating due to the impact of tariff issues, slowing global economic activity, and tighter monetary conditions.

The commodity sector was pressured throughout 2018.  The industrial metals sub-index had the lowest return for the year among the sectors we track with a decline of -19.5%.  Prices for metals such as copper and nickel dropped sharply on weaker demand from China and other countries due to trade tensions and slowing economic activity.  The petroleum sub-index also declined over 19% for the year.  West Texas Intermediate crude oil (WTI) traded higher for most of the year reaching as high as $76.40 per barrel in early October, which was the highest level since 2014.   However, the price of WTI sank over 40% during the fourth quarter due to an unexpected supply demand imbalance.  Inventories reached elevated levels.  High production in the U.S. was one factor.  The unexpected waivers related to U.S. sanctions on purchases of oil from Iran also had a major impact since Saudi Arabia and Russia had been ramping up production earlier in the year to offset the expected supply reductions related to the sanctions.  The elevated inventory levels combined with declining demand for oil, particularly in Asia, pressured prices.  Saudi Arabia and Russia have since agreed to cut production.  The agriculture sub-indices also had negative returns for the year as prices for grains and livestock fell when China and other countries cut purchases of U.S. products in retaliation for U.S. imposed tariffs.

We have a cautiously optimistic view for 2019 financial market returns.  U.S. economic fundamentals are supporting a solid environment for corporate earnings growth.  While economic and corporate earnings growth are expected to remain solid, the rate of growth is likely to slow off multi-year peaks as comparisons to the prior year become more challenging.  China’s economy is slowing and the impact is being felt not only in China but also by its various trading partners.  However, the Chinese government is taking actions to stimulate economic activity and to offset the impact of U.S. tariffs.  Economic fundamentals are improving in various other emerging market countries.  Valuations are attractive for various asset classes, particularly global equities, since they have come down to below historical averages after the 2018 sell-off.  As in any year, investors are faced with various risks. Top of mind is the progress, or lack thereof, on the trade front.  The impact of future FOMC actions is another key risk especially if the FOMC raises rates above the neutral rate (the rate that neither spurs nor constrains growth) and chokes economic activity.  Therefore, an adequately diversified portfolio including growth and risk reduction focused investments continues to be a prudent strategy.  We also recommend using periods of market strength to raise any cash needed to support spending needs over the coming 12-24 months since we expect financial markets to continue to experience bouts of heightened volatility.

The statistical information contained in this commentary has been compiled from publicly available sources and is presented to you for your review and for discussion purposes only. The information contained in this commentary represents the opinion of the author(s) as of its date and is subject to change at any time due to market or economic conditions.  These comments do not constitute a recommendation to purchase, sell or hold any security, and should not be construed as investment advice or to predict future performance.  Past performance does not guarantee future results.

 The statistical information contained in this commentary was derived from sources that Vogel Consulting, LLC believes are reliable, and such information has not been independently verified by Vogel.  Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Russell Investment Group.  An index is not managed and is unavailable for direct investment.