QUARTER 4 2018 COMMENTARY
Don't Fight the Fed
In a quarter that included trade tensions, a heated mid-term election, and a potential “hard Brexit,” the Federal Reserve stole the spotlight by raising interest rates during a stock market downturn—the first time it has done so in decades.
The turmoil that rocked virtually all markets abruptly ended the decade-old bull market in U.S. stocks.
Throughout 2018, tighter monetary policy pushed equity prices lower, despite strong corporate earnings.
The Federal Reserve has signaled a change in monetary policy expectations for 2019 due to waning growth and inflation.
We expect Fed action to again drive market performance in 2019.
Martin Zweig may be best known for his October 16, 1987 appearance on Louis Rukeyser’s Wall Street Week when he predicted a looming stock market crash. On the next trading day, which became known as Black Monday, the market dropped 23%. But Zweig also coined the pithy axiom "don't fight the Fed" – a now commonly used phrase describing the influence the Fed has with monetary policy. Investors may not be familiar with Zweig’s aphorism, but after the fourth quarter of 2018, they definitely understand its meaning.
The nearly decade-long bull market in U.S. stocks ended abruptly during the fourth quarter. Upended by significant turmoil including: fears of a slowdown in China and the U.S., a potential “hard Brexit,” and intensifying trade tensions. But all of those took a back seat to the Federal Reserve’s December decision to raise interest rates during an equity correction. This marks the first time the Fed increased rates during a market correction since Paul Volcker swore to break the back of inflation in the late 1970s.
2018 4Q: Key Market Total Returns
In December investors worried about bear markets and monetary policy. In response to the downturn, the Federal Reserve materially altered their 2019 expectations for growth, inflation, and interest rates. The crucial path forward for monetary policy is unclear.
But why are investors suddenly worried about a seemingly insignificant 25 basis point increase in interest rates? Corporate earnings are strong, the labor market is robust and consumer balance sheets are healthy. So why the anxiety? The answer lies not just in the hike itself, but in its timing and in how it was communicated.
The tone of the quarter was set on October 3 when the S&P 500 hit its intra-day peak and Fed Chairman Jerome Powell indicated the Fed was prepared to raise interest rates several more times during this rate hike cycle.
"We may go past neutral, but we're a long way from neutral at this point, probably."
Markets dropped in response. It was not until a speech on November 28 that Fed Chairman Powell appeared to revise his stance.
“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.”
Yet capital markets were calmed only briefly, and the downturn continued into December. In fact, between October 3 and December 26, the S&P 500 fell 20.2%. Its fourth quarter decline was of a magnitude not experienced since 2011. In 2018, global markets produced the most broadly negative year in more than two decades. Though paltry, cash gained 1.9% which made it the top performing global asset class.
While the stark contrast in the Chairman’s comments over such a short period of time spooked capital markets, the change in Powell’s sentiment was made even more evident through the revision in the Fed’s 2019 rate increases. Four increases were widely anticipated for 2019, but at the December meeting, they were reduced to approximately one or two hikes. While the path is lower, investors remain skittish. Interestingly, investors seemed much more focused on Powell’s interest rate comments than on the $50 billion bond reduction of the Fed’s balance sheet, which could be far more disruptive.
Inflation, jobs numbers and GDP have also played a role in altering the path of interest rates. The Consumer Price Index (CPI) hit a high of 2.9% during the summer and ended the year at 2.2%. The jobs market remained strong during the fourth quarter. December non-farm payrolls were robust, hitting 312,000. The three-month rolling average reached 254,000—a 50,000 increase from the previous quarter. As we start 2019, the Atlanta Fed GDPNow “Nowcast,” which attempts to estimate current-quarter growth using real-time economic data, suggests fourth-quarter growth to be 2.6%. This represents a slowing relative to third-quarter GDP, which was 3.4%. These metrics further support the Fed’s decision to reduce action in 2019.
Value stocks outperformed growth stocks during the fourth quarter but still underperformed for the year, while small cap stocks trailed large cap for the quarter and year. Within the large company universe, Value declined by 11.7% during the quarter, leaving it down 8.3% for the year. Growth was lower by 15.9% this quarter, down 1.5% for the year. Within the small cap space, Value declined 18.7% in the quarter, pulling it to a loss of 12.9% for the year. Small cap growth lost 21.7%, causing it to lose 9.3% in 2018.
Third-quarter S&P 500 operating earnings posted year-over-year growth of 32%, slightly above the 28% expectations coming into earnings season. This marked the fourth consecutive quarter of +20% growth, but analysts expect this trend will slow as the initial jump in earnings from corporate tax cuts has ended.
Sectors that are more defensive or more sensitive to interest rates performed relatively well during the market’s decline. Only utilities, up 1.4%, generated positive returns in the fourth quarter while real estate and consumer staples were down single digits (-3.8% and -5.2%, respectively). The worst performer was energy, which lost 23.8%, primarily due to the 38% decline in West Texas Intermediate crude oil prices. For the year, only utilities, health care, and consumer discretionary were positive. The “darling sector,” technology, outperformed the broad market by ending 2018 down by just 30 basis points.
There was meaningful movement in the 10-year and 2-year spread in the last quarter of 2018. After peaking at 3.24% in early November, the 10-year U.S. Treasury note moved significantly lower and ended the year at 2.69% - only a 29 basis points increase from the start of 2018. The 2-year note followed a similar path for the quarter and year. After topping out at 2.98% in early November, it ended the year at 2.48% - 50 basis points from the start of the year. While the spread between the 10- and 2-year Treasury yields ended 2018 at 21 basis points, the relationship did reach single digits on an intra-day basis in December. We continue to watch this spread closely as it is an important leading economic indicator.
Higher quality fixed income securities outperformed lower-rated securities during the quarter. Municipal bonds, as measured by the S&P National Municipal Bond Index, gained 1.6%, which was its return for 2018. The Bloomberg BarCap U.S. Aggregate Bond Index was also up 1.6% in the quarter, leaving it flat for the year.
Every developed country posted negative returns during the quarter, as well as negative returns for the year. While the end of the year did not bring with it a Brexit resolution, it did mean the end of the European Central Bank’s quantitative easing program. Although this was well telegraphed—much like the end of the U.S. program - it means a new regime for capital markets, which bears watching.
Emerging markets held up relatively well during the quarter. They lost 7.4% and were down 14.5% for the year. Brazil, up 13%, was the top performer for the quarter after the October election of far-right candidate Jair Bolsonaro. The debt and currency crisis that hammered Turkish stocks earlier in the year finally took a breather, pushing Turkish stocks up 5% for the quarter. China’s stock market continued its slide during the fourth quarter, down 11%. For the year, China was down 19%.
Given the market’s volatility and the focus on the Federal Reserve’s actions, the U.S. mid-term elections received little attention after the results gave Democrats a majority in the House of Representatives. The subsequent shutdown of the federal government, which has dragged into the new year, demonstrates once again that the bar should be set low for major policy initiatives in 2019.
This should put the market’s focus squarely on monetary policy. The FOMC will be at the forefront due to its decisions on interest rates and balance sheet normalization. As warned by Martin Zweig and made apparent in 2018, financial conditions often take precedence over strong earnings (that were above expectations), and financial conditions are largely set by Fed policy and comments. If the fourth quarter is any prelude, we should expect continued volatility in 2019 as the Fed’s path is more uncertain than ever.