For the equity markets in the US and abroad, 2018 started with a bang. S&P 500 Index (the broad US Equity Index) was up by more than 19% and the MSCI Emerging Markets Index was up by more than 24% in 2017. The US Fed had raised rates three times in 2017 by 0.25% each and was projecting another three 0.25% rate increases in 2018. The tax cut bill had been passed and the US Economy seemed to be on track to grow by more than 2%.
But January and February evolved into a treacherous six-week period and the markets rapidly declined by nearly 10%. However, by mid March, the markets were marching ahead and with earnings reports coming out strong, the markets seemed to find their bearing.
By the end of the third quarter we had fully recovered the early losses and then some. The markets were roaring to new highs so much so that by late September/early October, markets were at all-time highs.
By the end of September, the tech heavy NASDAQ Composite Index was up by nearly 15% and S&P 500 Index was up by about 9%.
Despite being down by 19% for the 4th quarter so far, S&P 500 Index is down by 9.7% for the year to date. Six out of 11 S&P sectors have had double digit declines. 2018 is turning out to be first year of negative returns since 2008. What caused this huge swing of 19% in the fourth quarter and, more importantly, what does it portend for 2019?
The negatives are pretty well known and which haunted the markets for all of 2018 but accelerated in 2018Q4 and quite a few of the issues will be present in 2019.
So far, we know the following:
- The financial conditions (ie. Interest rates) tightened and will continue to be tightened (despite an
- expected slowdown in 2019)
- The trade dispute has gone on for too long, which was quite unexpected
- The on-again off-again trade pact with China is not only affecting the Chinese economy but also the global economy, resulting in a slowdown in world economic growth
- Earnings growth rate is peaking with year on year comparisons becoming tougher in 2019 after the record
- earnings for many firms in 2018
- The fiscal stimulus is fading
- Credit spreads are widening
- The yield curve is flattening
- Brexit is a wild card in terms of how the divorce from the EU is going to play out
- US Congress is divided and will likely be a roadblock to pro-growth measures like an infrastructure bill (where we are going to get the money from for something like infrastructure is a huge question mark)
- The Trump Administration seems to be in quite a bit of disarray
- There is a specter of the Fed Chief being fired without cause (despite what the Secretary of Treasury is
- telling us)
- The risk of policy mistakes by the Global Central Banks across the world in withdrawing crisis era
- measures is rising
Despite the feeling of angst, there are some positives as we enter 2019:
- Entering 2018, the forward 12-month price to earnings ratio for the S&P 500 Index stood at 18.3x. As we end 2018, it is currently 14.2x, which is a slight discount to its 10 year average:
- Currently the earnings yield on the S&P500 Index is about 7% and the 10 Year treasury yield is ~2.75% and, so the difference (spread) between the two is 4.25%. Last year, the difference was ~3%. Historically such a widening of the spread has suggested better returns over the succeeding 12 to 18 month period.
- Entering 2018, the Personal Consumption Expenditure inflation rate (the preferred FED inflation indicator) was at 1.6% and it is currently at 1.9% – below the Fed’s stated objective of 2% inflation. This number could actually be lower because it does not yet account for the full decline of oil prices.
- Entering 2018, the Federal Reserve projected 3 rate increases and went for 4. Exiting 2018, the Fed is indicating 2 and is suggesting we are close to neutral rate policy. Furthermore, we seem to be at the end of the rate hiking cycle based on Fed commentary.
- Last time we had a growth scare in 2016, the Fed did not raise rates for a full year (Dec 2015 to Dec 2016)
- Fed Chairman Jay Powell in the speech to the Economic Club of NY on November 28, 2018 said, “Large, sustained declines in equity prices can put downward pressure on spending and confidence. From the financial stability perspective, however, today we do not see dangerous excesses in the stock market.” This would seem to suggest that the Fed would be deeply concerned and ready to act if the declines start impacting consumer spending and the general economy.
- Yet another parallel occurred in 1994/95 time frame when the Fed started raising rates in Feb 1994 after a prolonged period of low rates to tackle the early 1990s recession. US real GDP growth rate was 4%, the Fed raised rates for all of 1994 and the S&P 500 was down by 1.54% in the year. Real GDP growth went down in 1995 to 2.2%, the Fed reduced rates in July 1995 and the S&P 500 was up by nearly 34% in the year.
How have the markets generally done after such a gut wrenching 19% decline in a quarter?
S&P 500 returns since 1940 tell us that a decline of this magnitude in a quarter is generally followed by strong returns in one, three and five years later as the table below indicates:
Source: Marketwatch
Does this mean that we are headed towards a better period than in 2018? Perhaps. But it may not be a smooth trajectory. The narrative can still be scary – the trade negotiations go awry, earnings estimates get slashed, growth slows severely, the Fed makes a policy mistake, Brexit has unintended consequences or impeachment of the President starts. Above all, the President continues on an unprecedentedly irrational path with no constraints on him.
This is a volatile time in the market that I am monitoring constantly. There is a daily stream of news that is affecting the market one way or another, which I believe will continue for the short term. I still believe that the long-term outlook of the market is positive and do not recommend taking any emotional decisions based on the headlines we are reading.
As we enter the new year and gain more clarity around the current market environment and issues that were mentioned previously, I will continue to update you all.
Sanjiv Jhaveri
December 25, 2018