In a year that began with optimistic fervor on lower taxes, 2018 ended instead with a painful stock market decline. After a 2.7% drop on Christmas Eve, the S&P 500 had fallen 19.8% from its high of September—very close to the 20% threshold considered a bear market. So while the nearly 10-year-old bull market may still be alive, it’s only by the smallest of margins.
Other indices, such as the technologyheavy NASDAQ (-23.6% from peak to trough) and the Russell 2000 Small Cap Index (-27.2%), did actually fall into bear market territory. A strong rally in the final week of the year lessened the pain somewhat but the S&P 500 still trimmed 13.5% in the fourth quarter to end lower by 4.4% for the full year. 2018 was the first negative calendar year for the S&P 500 since the decline of 37% in 2008.
|Market Index Returns as of December 31, 2018|
|Index||4th Quarter||1 Year||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||-13.5%||-4.4%||9.3%||8.5%||13.3%|
|Russell Midcap (US Mid Cap)||-15.4% –||-9.1%||7.0%||6.3%||14.0%|
|Russell 2000 (US Small Cap)||-20.2%||-11.0%||7.4%||4.4%||12.0%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||-11.9%||-14.8%||4.4%||0.9%||6.9%|
|MSCI EM (Foreign Emerging)||-7.5%||-14.6%||9.3%||1.7%||8.0%|
|Barclays Aggregate Bond||1.6%||0.0%||2.1%||2.5%||3.5%|
|Barclays Muni Bond||1.7%||1.3%||2.3%||3.8%||4.9%|
|Past performance is not an indication of future performance.|
Providing some relief, government and high-quality corporate bonds held up well despite another Federal Reserve rate increase. The Fed’s 0.25% Fed Funds rate hike in December marked the fourth such increase in 2018 and the ninth in three years.
One driver of the selloff is the prospect of (and reality of) higher interest rates. If the ultra-low interest rate environment of the last decade contributed to higher prices for risk assets like stocks and real estate, it stands to reason that higher rates will serve as a headwind to further price increases for these assets going forward. Interest rates remain quite low relative to history but they are significantly higher than several years ago, especially for short-term borrowers. Corporations that typically borrow for five years or less will face higher interest expenses, negatively impacting earnings.
In last quarter’s commentary, we said that Republicans would likely lose control in the House which would lead to more of a stalemate in Washington. We just didn’t think it would happen before the newly elected politicians took office on January 3rd. The US government began a partial shutdown on December 22nd without a new funding bill in place. Government shutdowns like this aren’t unheard of but the third in a single year is unusual. We are at the point (around two weeks) where shutdowns begin to hamper the economy. While President Trump and Congress dig in over the border wall issue, the effects will trickle down to more and more Americans. We don’t think this will have a lasting effect on the market.
On another front, President Trump continues to fight for fair trade with China. He and Chinese President Xi agreed to a 90-day truce on trade tariffs back on December 1st while they work toward a sustainable long-term solution. China already announced tariff cuts while the US delayed tariffs on over $200 billion in imports. China even pledged to resume buying soybeans—to the great relief of US farmers. The first face-to-face negotiation will occur in the second week in January. The outcome of these talks will impact the global economy in 2019 and beyond.
EU and UK leaders continue to deal with their own political battles related to Brexit. The two-year waiting period for the UK to leave the European Union ends in March. UK Prime Minister Theresa May successfully negotiated withdrawal terms with EU officials but canceled a final vote by the UK Parliament after it became clear that the terms of the agreement would not be supported. As March approaches, three outcomes are emerging: Brexit with May’s deal (least likely), Brexit with no deal (creates significant disruption in trade and movement of people across borders) or another referendum for British citizens to vote again on staying in the EU (unclear if another vote would be legal). Brexit will likely loom large in 2019. It appears that markets are bracing for Brexit with no deal given that time is short.
Despite all the political handwringing across the globe, the US economy is growing. Once all the numbers are in, US GDP growth for the year is projected to come in at a healthy 3%. It is important to note that 2018 GDP enjoyed a nice boost from the tax cut passed in December of 2017; the impact of lower tax rates will be of less significance in 2019. Estimates for GDP growth in 2019 are positive though slightly lower at around 2%-2.5%. At 3.7%, the unemployment rate is the lowest it has been since 1969. Fed officials cited this strong economic data in raising rates again in December, even as stock market investors signaled (by selling stocks) that another rate increase was not needed. Fed officials say they don’t consider the stock market in rate decisions but in practice, raising rates during falling markets is extremely rare. Chairman Powell explained that the Fed will be more careful or “data dependent” going forward but reiterated that Fed officials would not have supported the recent rate hike if they believed the next recession was imminent.
Of course, what moves the stock market is corporate earnings growth and 2018 brought spectacular earnings growth. Earnings for the S&P 500 companies are expected to have grown by over 20% in 2018, the best year since 2010. Much of the increase is attributable to the reduction in the corporate tax rate and there won’t be a similar boost for 2019. FactSet currently estimates S&P 500 earnings growth of 7.9% in 2019. Since 1950, every US recession has been marked by falling corporate earnings; investors will be watching closely for revisions to 2019 estimates.
We begin 2019 with the economy and corporate earnings on seemingly stable footing. Growth may be slowing for both, but they are still moving in the right direction. And after the market sell-off, stock valuations are lower than they’ve been in several years. Higher interest rates, the government shutdown, trade wars, and Brexit all pose real risks to growth but the greatest risk may be that falling sentiment becomes a selffulfilling prophecy. Measuring this risk is difficult of course; there has been no shortage of worrying and dire predictions throughout the current bull market and yet the market has continued its climb until only recently. The recent volatility might turn out to be a clearing of the brush to make way for new growth or it may turn out to be a sign of more declines to come…we just don’t know yet. One thing we do know: recessions, corrections and bear markets are normal. The chart above makes this clear and is a good reminder of the importance of owning a portfolio that is appropriate for your risk tolerance, your need for liquidity and your need for growth.
Matthew S. DeVries, CFA