No ‘Santa Rally’ This Year
The final quarter capped off a very tricky 2018 for portfolio managers, with most asset classes producing negative returns for the year. In fact, around 90% of the 70 asset classes tracked by Deutsche Bank recorded negative total returns (in USD terms) through mid-November – and further weakness in December is unlikely to have improved the situation. Broad sell-offs across all asset classes such as these are infrequent events and the benefits of holding a diversified portfolio are temporarily diminished as a result. Furthermore, the final quarter saw many stock markets experience their second correction of the year (a fall of 10% or more from recent highs). Investors appear to be indiscriminate sellers at present, a trend seemingly accentuated by passive investment vehicles occupying an ever-higher proportion of the market.
Historically, December is one of the strongest months of the year for stock market returns; however, 2018 has certainly bucked that trend. At the time of writing, the major US stock market indices were on track for their worst December returns since the Great Depression, having fallen 7% or so during the month. The S&P 500 has now fallen around 15% since the beginning of October. Worse still, a number of stock markets – including the German DAX, Italian MIB, Shanghai Composite and Japanese TOPIX – have now entered the bear market territory, having fallen at least 20% from their 2018 highs.
Markets had pinned their hopes on a more dovish outlook from the US Federal Reserve and, despite the protestations of President Trump, the Fed raised the interest rate at their December meeting to between 2.25% and 2.5%. Fed officials cut their growth outlook for the US economy from 2.5% to 2.3% and suggested that there was a high degree of uncertainty regarding the path of future rate rises. Median projections of three rate hikes next year have fallen to two and Governor Powell suggested that the base rate was ‘just below’ estimates of a neutral level (the level at which rates neither stimulate nor constrain the economy). However, markets responded badly to the Fed’s narrative, sparking the worst market reaction to a rate rise since the beginning of 1994.
Partial Yield Curve Inversion
December saw a partial inversion of the US yield curve as two-year US government bonds yielded more than five-year bonds. While more attention is paid to the difference between the two-year and ten-year, there was a certain degree of trepidation from investors, especially with the ten-year bond yielding only marginally higher than the two-year.
According to research from the San Francisco Fed, an inverted yield curve has preceded the previous nine US recessions. Whilst this signal is currently flashing amber, not red if a broader inversion of the yield curve does occur, history suggests that the average lead-time to a recession is around 12-18 months with traditionally strong equity returns during this period.
Outlook for 2019
The recent corrections in equity markets have been influenced by a multitude of factors; however, principal among them was a significant downgrade in earnings expectations as global economic growth slows and transitory factors such as US tax cuts recede. According to Factset, the estimated Q4 earnings growth rate for the S&P 500 is 12.8%. If accurate, it would mark the fifth straight quarter of double-digit earnings growth. The estimates for the calendar year 2019 are currently in the high single digits. Again, if accurate, the numbers are solid and remain above their long-term average (circa 6.5%). Valuations are now at their lowest levels for a number of years while earnings growth is expected to slow next year but not contract. For longer-term investors, the recent sell-off presents something of a buying opportunity and despite being in the latter stages of the current market cycle, we have been selectively adding to equity positions. Our view is that it is too early to pull back on risk taking; however, a degree of caution is warranted. Were some of the geopolitical issues to be resolved, such as trade tensions between the US and China, this would help to boost investor sentiment going into the New Year.
In the UK, a negotiated Brexit settlement remains the most likely outcome, which would be positive for the UK economy and Sterling over the next year or so. In addition, the fact that Parliament will get more of a say in the outcome would suggest that the likelihood of a no-deal Brexit has diminished given parliament’s lack of appetite for such a scenario. A no-deal Brexit is still possible, however, with Capital Economics putting the probability at 20%, with a resultant GDP growth of -0.2% for 2019 (their central scenario is an acceleration to 2.2% on a deal of some sort being passed).
Consumer confidence in the UK has fallen to a five-year low despite very low unemployment (4.1%) and wage inflation reaching a ten-year high recently (3.3%). Brexit uncertainty is starting to have a tangible impact on consumer spending, with UK retailers warning of a dire Christmas period. One would assume that a resolution, one way or another, would at least allow some of the Brexit fog to clear.
Disclaimer: The views thoughts and opinions expressed within this article are those of the author and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.