Quarterly Review and Outlook – 4th Quarter 2018

The year that nothing worked

 Wall Street analysts entered 2018 with a broadly bullish outlook, buoyed (perhaps) by the momentum of 2017. The average prognostication for the S&P 500 index called for gains around 8 percent, with some more bullish soothsayers expecting double digit returns. In the end, the market gave up all of its mid-year gains to finish under water. Large caps, small caps, US and international, all produced losses of varying degrees as the year came to a screeching halt with the largest December loss since the Great Depression.

Ordinarily, one might expect other asset classes to pick up the slack (the fundamental premise of diversification). Not this year. Bonds, gold, oil, real estate, all generated losses. 2018 was a year in which nothing worked.

The S&P 500 ended the year down 4.4 percent, a reminder that stock market forecasts are fun to read but should not be relied upon to make investment decisions. Only the more defensive utility and health care sectors managed to eke out gains as investors fled to relative safety. Tech stocks rallied smartly during the first half, but gave up their gains and then some in December. US small caps, developed international stocks, and emerging markets all retreated by 10 percent or more for the year. The worst performing sector proved to be energy, as oil prices tumbled by 45 percent during the fourth quarter of the year. Good for motorists, not so great for investors.

Economic news has generally been positive, particularly on two fronts: employment and corporate earnings. The US has now enjoyed 100 consecutive months of job growth, more than twice as long as the previous record streak ending in 1990, and January’s numbers showed little evidence of slowing.

 Meanwhile, corporate profits surged in 2018, rising by an average 25 percent rate for the first 3 quarters of the year, and a respectable 13 percent so far for the final quarter. Much of this impressive performance can be credited to the tax reform bill enacted in late 2017 which cut corporate tax rates by 40 percent at the margin. The lion’s share of this profit windfall found its way into the hands of shareholders in the form of stock buybacks and dividends, adding more impetus to the market’s upward momentum.

Heading into the fourth quarter, however, that momentum reversed as a few tiny cracks began to appear in the foundation. The impact from the tax cuts seems to have waned almost entirely, leaving behind nearly $2 trillion in new debt over 10 years like a hangover after a wild party. GDP growth surged briefly in response, but now seems headed back to the long-term trajectory of 1.7 to 2 percent annual growth that prevailed previously.

 Likewise, corporate profits spiked early in the year thanks in part to the beneficial reduction in corporate income taxes and a shift to a more globally competitive territorial foreign tax regime. In the wake of startlingly robust profits in 2018, analysts expected earnings to decline in Q1 of ’19, the first such decline in three years. Given investors’ emphasis on earnings growth as the key to stock prices, and the relative overvaluation US markets, it was hardly a surprise that a correction ensued.

Adding to the pressure on stock prices was a growing concern that the Fed would follow through with its previously announced tightening plan. Besides systematically reducing the bloated balance sheet, the biggest worry for the stock market was the expectation of three to four more interest rate hikes in 2019. As the correction deepened and evidence mounted of a gradual slowing in the economy, the Fed reversed course and backed off of its first scheduled rate increase of the year, and softened its rhetoric to hint that additional hikes were unlikely given current conditions. The bond market had reached the same conclusion independently, driving the 10 year Treasury yield down to levels last seen a year ago. The result was a blowout start to the New Year, the biggest rally in stock prices for the month of January in over 30 years, nearly erasing the December losses. We observe that it is somewhat unusual for stock and bond markets to disagree, and that in the longer-term, the bond market generally prevails. Also note that while it doesn’t happen often, last quarter’s commentary suggested a halt to rate hikes, somewhat contrary to prevailing opinion thanks to a compelling paper from the St. Louis Fed.

Yet despite the strong springback of stock markets so far in 2019, signs of impending stress on both the US and global economy are emerging for the intermediate term ahead. Sales of cyclical big-ticket items like autos and RVs have been tepid and appear to be declining lately. Household debt has steadily increased since the financial crisis and may be putting pressure on consumer spending, which makes up nearly 70 percent of US GDP. After a strong holiday shopping season, retail spending has slowed. And capital investment plans by American businesses are clearly constrained due to increased risks arising from higher input costs, a rising dollar, and worsening drag from a trade war with China. And although a modification of the 25-year old NAFTA agreement has been hammered out among its North American signatories, Congress has yet to take up the measure and some concern exists regarding its prospects in the absence of significant changes. A collapse of NAFTA would wreak havoc on the economies of the US, Canada and Mexico.

As previously noted, the national debt is rising in part due to the tax cuts of 2017, but also in response to habitual annual budget deficits. The Congressional Budget Office, the official scorekeeper for budgetary measures, has estimated that total debt held by the public will balloon from its current 78 percent of GDP to over 100 percent within just 10 years. Concomitant with that profligacy is the burgeoning cost of interest on the debt, an additional obstacle to future growth.

Investors are also closely watching the relationship among yields of various government bond maturities, particularly the difference between the 2-year and 10-year US Treasury bond rates. This differential, or spread, is a measure of investors’ short-term expectations relative to longer-term forecasts and incorporates expectations of future inflation and economic growth. Typically, longer-dated bonds carry higher yields, but in recent months the spread has narrowed. A graph of this normally upward-sloping relationship is called the yield curve, and when it slopes downward (or “inverts), it has proven to be a harbinger of impending recession. The signal is not infallible, but has proven to be remarkably predictive of cyclical declines 6 to 12 months later, and it has been flattening.

 The housing market is also feeling a bit of a pinch. New single family home starts have declined steadily since peaking in mid-2017, despite the tailwind of still historically low mortgage rates and even recent declines as the Treasury yield has fallen. At least some of the softening can be attributed to the overhang of student loan debt among Millennials, who have seen their home ownership decline by 9 percentage points since 2008, but home ownership generally is down from almost 69 percent before the crash to around 64 percent today.

With the economic expansion now one for the record books in terms of its duration, it is clear that a cyclical decline is within sight over the next few years. Most observers do not expect a recession in 2019, as the robust job market and strong corporate profits suggest sustainable momentum. But the outlook for 2020 is cloudier, with geopolitical risks growing alongside an escalation of trade tensions. For now, press on.

Christopher A. Hopkins, CFA

© 2018 Barnett & Company


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