The S&P 500’s long winning streak of nine consecutive years with positive total returns came to a halt in 2018 with the widely-followed index retreating by -6.5% (-4.5% including dividends). After suffering a double-digit correction in the first quarter, the market climbed back to fresh highs over the summer before retreating again in the fourth quarter. A steep December drop and Christmas Eve rout sent the S&P 500 down 20% from its highs attained just a few months earlier. Interestingly, the index recorded its first annual loss ever after being positive for the first three quarters of the year. Other major indexes fared even worse in the tumultuous year with the Russell 2000 (small caps) dropping -11% while the All Country World Index (excluding the U.S.) fell by -14%.
It wasn’t just stocks that struggled in 2018. Other than small gains earned by sitting in cash, it was a rare year in which diversified portfolios faced losses on virtually all fronts. In fact, it was such a difficult environment to make money that, according to research from Deutsche Bank, roughly 90% of asset classes had negative total returns in 2018, marking a record going back to 1901 (as seen on the chart below).
A multitude of factors contributed to the sour mood on Wall Street and tumultuous trading over the last several months. Higher interest rates along with the Fed signaling its desire to continue raising interest rates in 2019, the disruptive trade dispute with China, fears of Britain crashing out of the EU without an exit agreement, and year-end tax related selling all contributed to the negative sentiment and declining asset prices. In addition, the ongoing government shutdown and perceived communication missteps by the Fed and the Administration exacerbated the precipitous December drop and wild daily price swings.
We enter 2019 on fragile and uncertain ground. There is an expectation that the U.S. economy will sputter and corporate profit growth will slow in the year ahead. With that being said, in the absence of a near term recession, there is a decent likelihood that the markets regain lost ground and possibly hit record highs in 2019. Since current valuations are already pricing in little to no earnings growth in the coming year, if the economy still expands (albeit at a slower pace than 2018) and earnings grow by the currently expected mid-single digits in 2019, stock prices should trend higher.
However, an end to the long U.S. economic expansion that began in 2009 is also a possibility. Avoiding a recession will not only depend on the strength of the U.S. consumer, but also macro factors including the Fed’s interest rate posture and the outcome of the U.S. and China’s trade negotiations. Even though the negative repercussions of higher borrowing costs and the tariffs are still filtering through the economy, consumer spending has proved resilient thus far. In fact, holiday spending this December registered the best growth in six years.
Another indicator supporting the case for market gains in 2019 is that, historically, the year following midterm elections (the 3rd year of the presidential cycle) is generally good for stocks. In fact, since 1947 there has not been a down year for the S&P 500 in the year following mid-terms irrespective of which party occupies the White House.
The Rate Debate
Bond prices were under pressure for most of the year as both short- and long-term interest rates moved up as the Fed adjusted the Fed Funds rate (0.25% on four occasions) and investors demanded higher longer term yields given heightened inflation expectations. Most market pundits and strategists declared the long bull market in bonds officially over when the yield on the 10-year Treasury bond eclipsed the psychologically and technically important 3% level during the year. However, as seen on the chart below, that declaration has once again proved premature as yields have subsequently moved back down and now stand at 2.7%.
The Fed has signaled their intent to raise rates twice in 2019 to 3% which in their view represents a “neutral” level where the economy can grow on a sustainable path with stable inflation. The markets are concerned that the Fed’s actions will snuff out economic activity and lead to a recession.
Economic Clouds Forming
Traditional economic indicators such as a flattening yield curve, slowing housing activity, plunging commodity (especially oil) prices, and widening credit spreads are flashing yellow that a slowdown, and possibly a recession, may be approaching. However, strong employment and consumer spending may enable the U.S. economy to continue to expand at a slower pace like it has for much of the time since the 2008 recession, rather than fall into a contraction. The unemployment rate continues to hold steady below 4% and first time unemployment claims, as seen on the chart below, continue to trend at a level consistent with a strong labor market.
With heightened volatility and clear evidence of a slowing U.S. and global economy, portfolio risk should not be stretched too far. Equity components of portfolios should remain balanced between U.S. and global equities with a tilt towards value and larger caps. Fixed income holdings should lean heavier on U.S. Treasuries of short to intermediate term duration rather than on longer dated, lower credit quality securities. Emerging market bonds and investment grade preferred stocks, which were pressured in 2018 by rising U.S. interest rates, may outperform in 2019 given their favorable yields and likelihood the Fed is close to ending their rate hiking campaign. Small allocations to these asset classes makes sense given their attractive risk/return profile.
Despite the potential for a market rebound, higher interest rates (the yield on T-bills is higher than that of the S&P 500) have created an environment where investors now have lower risk alternatives than stocks to earn decent, inflation-adjusted returns. Portfolios should be rebalanced to levels that leave room to increase exposure to equities should prices decline further in case the U.S. economy succumbs to a deeper slowdown.