In the 4th quarter a second correction for 2018 was experienced as stock market investor concerns grew over whether the U.S. economy reached its peak earnings growth potential. Additionally, continued trade negotiations and uncertainty regarding the Federal Reserve’s monetary policy led to a tumultuous end to 2018. While investors saw some relief in the last few trading sessions of the year, Christmas Eve’s sharp decline put the S&P 500 within a few points of what would be considered a bear market (that is a 20% decline in the S&P 500 from its peak).
While market volatility spiked in the 4th quarter of 2018, the U.S. economy is entering its 10th year of economic expansion following the global financial crisis. Real GDP measured an annual growth rate of 3.5% for the 3rd quarter suggesting the U.S. is far away from posting a negative growth rate. Keep in mind, the definition of a recession is when we experience two straight quarters of a negative GDP. Many leading economists and experts are forecasting growth to slow but continue at a rate somewhere around 2% to 2.5% for 2019. To give reference, the GDP growth rate was 1.5% in 2016 and 2.3% in 2017. S&P 500 returns for those years were 12% & 21%, respectively. Even if we did reach a peak growth rate in 2018, market returns could still fare better in 2019.
In December, the U.S. and China agreed to a 90-day truce where U.S. tariff increases would not take place until March of 2019. Some China imports could see tariffs rise from their current level of 10% to 25% in March if an agreement is not reached. While China’s growth is slowing, President Xi Jinping may not be overly motivated to give a lot of concessions to President Trump and the U.S. with the hope that the election year of 2020 could bring different leadership and perhaps an easier path toward negotiation. That being said, there are continued discussions between the U.S. and China and while analysts feel in the short term a major breakthrough would be unlikely, this does give hope that some progress could prevail.
U.S. monetary policy has also been a factor causing turmoil in our equity markets with investors eyeing interest rate increases and a tighter monetary policy. As expected, on December 16th, the Federal Reserve raised its benchmark interest rate a quarter-point to the range of 2.25 to 2.5 percent. They announced they will be taking a slightly more dovish approach going forward, lowering their projection for future hikes with officials projecting just 2 hikes for 2019. Additional comments by Fed Chair Powell in the beginning of January seemed to hint that these two projected rate hikes may not come to fruition. The market rallied with investors increasingly believing that the Fed won’t raise rates in 2019. The banking sector saw relief in particular from these comments with the largest U.S. banks all climbing around 4% on January 4th 2019. Still, investors should expect to see continued volatility in the stock market until there is greater clarity to what the Fed will do with rates moving forward.

U.S. Stock Market

After seeing stocks outperform in the 3rd quarter with a 7.2% return of the S&P 500, this key index declined in the 4th quarter by 13.5% creating a negative 4.4% total return for the year. Energy, materials, industrial and financial sectors were all hit hard, being down 12% or more for the quarter. Utility stocks performed the best for the 4th quarter as well as for the year posting a 1.4% and 4.1% return, respectively.

International Stock Markets

The 4th quarter was equally challenging to developed and emerging market economies. Governmental problems in the European Union may be even greater as U.K. Prime Minister Theresa May desperately tries to negotiate a “Brexit” deal with the rest of Europe. The developed international EAFE index declined 12.5% for the quarter. Emerging markets also struggled losing 7.5%. Return on international investment could be better for 2019 if the U.S. dollar were to fall or if global economic growth rates rise. This seems plausible seeing that many countries are in an earlier stage of their economic recovery.

Bond & Credit Markets

Bonds rallied at the end of the year posting a 1.64% gain for the 4th quarter as seen by broad based Aggregate Bond Index. Still, return for the index was flat for 2018. Expected interest rate hikes by the Fed are largely priced into the bond market ahead of time. If the Fed were to pause or raise rates less than expected, then this could provide a nice boost for bonds in 2019.
We do not expect inflation to be of any material consequence for 2019. The good news is this low inflation has put little pressure on the Fed. If inflation were to pick up, it would force the Fed’s hand, causing them to raise rates further. This is not expected with most forecasts for core inflation to be around 2% for 2019 despite the fact that wages should increase given that the U.S. is operating at or near full employment.
The yield curve remains very flat with a .2% spread between the 2 and 10 year treasury yields at the end of the year. If the yield curve were to invert, which is when short term rates are higher than long-term ones, this could be seen as a leading indicator of a potential economic slowdown. That being said, this economic expansion has been different than others. The Fed has distorted the bond market with their quantitative easing (QE) experiment that was used to help stabilize the economy during the great recession. Since this strategy was unprecedented, the past might not repeat itself and an inverted yield curve might not mean a recession is coming. Additionally, even when the yield curve has inverted and predicted a recession, equity returns are often positive for several months after the initial inversion. Prior to the last five recessions, the S&P 500 peaked 19 months on average after the yield curve inverted. A 21% average return accompanied this run up to the peak. The timing of if or when the yield curve could invert will largely depend on Fed policy which we will continue to monitor closely.

Oil Prices & the U.S. Dollar

Brent crude oil ended 2018 down 20% for the year to $53.86 a barrel. This marked oil’s first annual decline since 2015. While this puts more money in American’s pockets in the form of lower gas prices, it can have a negative effect on energy stocks.
The Wall Street Journal Dollar Index measures the U.S. currency’s performance against a basket of 16 others. For 2018, the index posted a 4.3% gain. The dollar strengthening made foreign investment for multi-national corporations challenging. These companies sell their goods or services in a foreign country’s currency but then had to convert this back into a more expensive U.S. dollar this year. It is important to be mindful of the price of the U.S. dollar since more than 40% of S&P 500 company revenues come from overseas. Should the dollar weaken in 2019, this will be supportive of higher revenues and asset prices.

2019 Perspective

Economic indicators are still positive with the December’s job report showing that U.S. employers added the most workers in 10 months as labor-force participation jumped easily beating consensus estimates. Additionally, the risk of a recession for 2019 appears to be low. Also keep in mind that back-to-back negative yearly returns of the stock market are rare. There have been only 4 instances since 1929 that stocks have posted a decline in consecutive years. Nevertheless, we feel that investors will experience challenges in 2019. Keep in mind that in an average year a stock investor sees the market drop 13.8% from a peak to a trough. With a healthy amount of political, international, and policy risk, we expect market volatility to remain prevalent throughout 2019.
Respectfully Submitted
CRA Investment Committee
Tom Reynolds, CPA
Matt Reynolds CPA, CFP®
Robert T. Martin, CFA, CFP®
Francis C. Thomas CPA, PFS
Gordon Shearer Jr., CFP®
Jeff Hilliard, CFP®, CRPC®