January 09, 2019
Monthly Market Summary – December 2018
December 2018 will be remembered for the brutal sell-off in U.S. equity markets. December was the worst monthly return for the S&P 500 index since February 2009. At the low point for the month on December 24, that index was down almost 15% from the end of November and about 20% from its all-time high in September. Equity markets rose in the closing days of the month so the index ended December with a return of -9.0%. Mid and small-capitalization (cap) stock indices declined more. The sharp sell-off in December erased the prior year-to-date gain and resulted in the S&P 500 index finishing the calendar year with a negative return for the first time since 2008. Non-U.S. equites also were mostly lower for the month, but the MSCI EAFE and MSCI Emerging Markets (EM) indices declined less than major U.S. equity indices. Crude oil prices also dropped sharply in December with West Texas Intermediate (WTI) falling about 13% on weaker demand due to slowing consumption in Asia along with high inventory levels as production in the U.S. and globally remained high. Most Treasury bond prices rose and yields declined in the risk-off climate as market participants shifted to the perceived safety of government bonds.
Market Indices – December 2018
What caused the dramatic equity market sell-off? Worries about weakening global economic growth were likely the main catalyst. The Federal Reserve Open Market Committee’s (Fed) latest projections for rate hikes in 2019 fueled worries that the Fed’s plan for continued tightening of monetary conditions will choke economic growth and therefore corporate profits. The Fed’s projections indicated two rate hikes in 2019, which is down from their previous forecast of three, but was still above the zero to one increase that many investors expected. Weaker data reports from Europe, Japan, and Asia also fueled slowdown concerns. For example, the composite purchasing managers’ index (PMI) for Europe was 52.7 at the last reading, which while still in expansion territory at above 50, was the lowest level in two years. Japan’s third quarter gross domestic product growth was revised lower in December to -2.5% from -1.2%. The China manufacturing PMI fell into contraction territory with a reading of under 50 at 49.4. This was the lowest level in three years. The continuing trade tensions between the U.S. and China, despite the on-going negotiations, added to the worries about the pace of future economic activity.
In the U.S. equity market, large and mid-cap stocks outperformed small-cap stocks as market participants favored more defensive positioning. Growth stock indices outperformed value indices in each of the market cap categories. Growth outperformed despite the utilities sector, which is typically considered a value sector, posting the best returns for the month. Other growth sectors, such as information technology and communications services, were among the best performing sectors. The value indices were pulled down by the significant declines in the energy sector, which had the lowest returns in the large, mid, and small-cap indices.
For the second consecutive month, the MSCI EM index outperformed U.S. and developed market equity indices. The EM had a return of -2.7% on a U.S. dollar basis. The MSCI EAFE index of developed international stocks had a return of -4.9%. Currency movements had only a modest impact on returns for U.S. investors in December and benefited the return for the EAFE index but lowered the return slightly for the EM index. The local currency return was -5.9% for the EAFE index and -2.5% for the EM index. There was little difference between the return for growth and value stocks in the EAFE index, but value outperformed growth in the EM index. On a geographic basis, among emerging market countries Mexico had the best return with a gain. Investors reacted positively to the budget proposal of the new administration which included a lower increase in government spending than expected. The sharp decline in oil prices provided a boost to countries, such as India, which are heavy oil importers. China had the lowest return as economic data reports, particularly retail sales and exports, showed continued slowing. In developed markets, the Pacific ex Japan region outperformed Europe and both regions outperformed the Far East.
U.S. bond market returns were positive in December for all sectors except for high yield bonds. The high yield bond index has a large weighting in energy company bonds. Prices for energy related bonds were pressured by the continuing plunge in oil prices. In the Treasury bond market, longer maturity bonds outperformed shorter maturity bonds. The benchmark 10-year Treasury bond yield declined during the month as risk averse investors sold equities and shifted to less risky government bonds. The 10-year Treasury bond yield closed at 2.69% on December 31 which is down from the yield of 3.00% on November 30. (As a reminder the yield was still higher than the December 31, 2017 yield of 2.40%.) Treasury bonds outperformed corporate bonds as the spread between the yield on Treasury bonds and corporate bonds widened on increasing concerns about slowing growth in corporate earnings.
The Bloomberg Commodity index had a return of -6.9% for December. For the third consecutive month, the steep decline in the price of oil was a primary reason for the negative return. The petroleum sub-index had a return of -9%. The price of oil continued to fall due to weakening demand from Asia while U.S. inventories are increasing and production by Saudi Arabia and Russia remains high. Natural gas also had a large decline for the month due to warmer than normal weather in the U.S. The industrial metals sub-index resumed its downtrend in December on concerns about slowing global economic growth. The agriculture sub-index also had a small negative return hurt by high supply levels even though China agreed to resume buying U.S. soybeans. The precious metals index had a solid gain helped by safe haven trading as equity markets sold off.
Vogel Consulting, LLC (Vogel) Tactical Recommendations
One change was made to our tactical allocation recommendations. We have moved our recommendation for fixed income to an equal weight from underweight. Yields are more attractive than they have been in a number of years especially for short to intermediate maturity bonds. The risk from interest rates moving higher and bond prices lower is moderating since it is likely the Fed’s policy rate is getting closer to what they consider neutral and therefore, the pace of interest rate hikes may slow since inflationary pressures remain moderate.
Our tactical allocation recommendations include an equal weight to U.S. large-cap, mid-cap, and small-cap stocks and to developed international equities. We recommend an overweight to emerging markets equities due to favorable relative valuations and growth potential. Within our equal weight fixed income recommendation, we continue to favor short to intermediate maturities. We continue to recommend an underweight allocation to hedge funds. Since our expectation is for a moderate rate of inflation, we recommend an equal weight to real assets. We continue to recommend an overweight to cash reserves that includes adequate cash 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.