Monthly Markets Memo - December 2018
by Dan Zalipski, CFA
Unless Santa delivers a last-minute present, stocks are looking like a real lump of coal as we close out the year. Bonds are also struggling this year in the face of rising interest rates, with the Barclays Aggregate Bond index sitting on a loss at the time of this writing. We may be witnessing some history in the making as the S&P 500 and the Barclays Aggregate Bond index have never both posted negative returns in a calendar year. This highlights what an unusual year 2018 has been for the markets.
We started the year with a strong January rally on the back of the tax reform that was passed the prior month. The rally was short lived as February ushered in the first of two market corrections of 2018. The first market correction was born out of fears that rising inflation would lead the Federal Reserve to become more aggressive with their expected rate increases. The correction persisted through the rest of the first quarter, retesting the lows when President Trump announced one of the first volleys in the then-developing trade war with China.
Reports convinced investors that inflation was not spiraling out of control. The market was even able to shrug off the brewing trade war with the consensus that the impact would be limited, and a resolution would be in place before the midterm elections. The market was volatile and choppy throughout the summer months, but generally trended higher. The focus was on strong corporate earnings growth boosted by tax reform. The S&P 500 surpassed January’s high by late August. New highs were made throughout the month of September.
The fourth quarter saw the second correction for 2018 on the back of Fed Chairman Jerome Powell’s comments that the Fed may have to aggressively raise rates three times in 2019 to prevent the strong economy from overheating. At the same time, rhetoric surrounding the trade war escalated to a new level causing investors to be concerned that a resolution was nowhere in sight. At the G20 this past November, President Trump struck a deal with Chinese President Xi to delay any further tariff increases until later in the first quarter as both nations continue to work towards a resolution. Powell eventually walked back some of his more aggressive comments, but still committed to two more rate increases in 2019 at the December Fed meeting. Closing out the year, the market continues to be erratic with volatile swings on any further developments surrounding trade or the Fed’s monetary policy.
You wouldn’t know it by the way the market is reacting, but the underlying fundamentals of the economy remain firm. Unemployment is near a five-decade low and wage growth looks to be showing some signs of life after a stagnant decade. The Institute of Supply Management’s monthly reports on the manufacturing and service sectors reveal that both continue to expand at a healthy pace. The Conference Board Leading Economic Indicators (LEI), an excellent predictor of recession, has yet to show weakness but does concede that growth may be slowing. That slowdown in growth is a concern hanging on the markets as investors ask if this is as good as it gets. We do anticipate a slowdown in corporate earnings growth as the simulative effects of the tax reform fade. There is also renewed concern over the expanding budget deficits feeding the national debt at a time when interest rates are rising. Finally, those rising interest rates are throwing some cold water on the rate-sensitive sectors of the economy, such as housing. These headwinds are real and should not be ignored, but as long as we continue to see relative strength within underlying fundamental drivers of the economy, concerns of an impending recession are premature. Therefore, we do not believe drastic changes to the portfolios’ allocations are appropriate and continue to use the market volatility to seek out attractive opportunities.
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." - Warren Buffet
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