- After the worst December since 2008, stocks rally in the early days of January based upon a strong jobs report and supportive comments from Fed Chief Jerome Powell.
- Global PMI data has decreased lately, most notably in China and the Euro-zone. In Europe, worries around Brexit negotiations and German manufacturing persist which have dampened growth expectations.
- After the selloff, valuations look attractive given the high growth expectations, but rising uncertainties including the government shutdown leave us with a cautious outlook.
- Inflation remains modest by historical standards, which along with slowing growth concerns should help prevent further monetary tightening in the coming months.
What Piqued our Interest
Thank goodness December is now behind us, as the stock market has rebounded quickly from what we considered to be an overdone and somewhat irrational selloff. In our January 3rd commentary, we noted that the market was focused more on fear than fundamentals, and it appeared that automated and algorithmic trading likely exacerbated the correction during the low volume trading days around the holidays. As it turned out, last month’s 9% decline marked the 2nd worst December return since the market dropped 14.5% during December of 1931. In fact, going back to 1929, there have only been 32 months (out of 1080) with worse monthly returns. 21 of those months occurred during the Great Depression/World War II era, while another 2 months each occurred during the dot-com meltdown and the global financial crisis. In other words, rarely do we experience such dramatic selloffs unless during periods of extreme economic distress. On the bright side however, the average S&P 500 return following the 32 worst months was +5.1% over the next 6 months, and +6.8% over the next 12 months. While we believe that there still may be problems brewing on the horizon, it appears for now at least that the markets have stabilized and can focus on 4th quarter earnings season.
On January 2nd Apple surprised investors by preannouncing 4th quarter revenue of $84 billion, notably lower than the average analysts’ estimate of $91 billion. In their first negative guidance in over a decade, the company cited significantly greater macro weakness in emerging markets, particularly in China, as the primary cause for weaker sales. Apple’s preannouncement has created further uncertainty as we head into earnings season… Could this be a “canary in the coal mine” scenario, and will more companies lower revenue guidance based upon trade war uncertainties and slowing global growth? Since January 2, Samsung also followed suit and announced lower revenue expectations, and overall it seems the bar of expectations has been lowered compared to previous quarters. Despite that more companies are citing a negative impact from China on their earnings calls, overall the results of Q4 earnings are expected to be solid. On average, analysts are estimating a 15% year-over-year increase in 4th quarter profits, which would mark the fifth-straight period of double-digit earnings growth, according to Factset Research. On the negative side however, Factset also noted that in December analysts cut their earnings for 2019 on more than half the companies in the S&P 500, the first time this has happened in two years.
As we look towards the upcoming earnings season here in the U.S., we cannot ignore the many potential problems brewing overseas. Using the JP Morgan Global Composite PMI as a proxy for global economic output, we observed notable weakness across multiple segments. (Note: PMI stands for ‘Purchasing Managers’ Index, which is an indicator of economic health for both manufacturing and service sectors). According to the index, total new business in the global economy rose at the slowest pace since September 2016, as international trade has deteriorated, and new export orders have declined. China’s official manufacturing PMI slipped to 49.4 in December, which is now in retraction territory and marked its lowest reading since July 2016. According to the report, new orders fell into contraction, while New export orders and imports also contracted at faster rates. China’s stats bureau conceded that downward pressure on market demand has increased, while companies remain cautious about the outlook.
The U.S. and China concluded three days of mid-level trade talks on January 8, which supposedly ended on an optimistic note. The two sides apparently moved closer on issues such as increased Chinese purchases of U.S. goods and services, along with further opening of China’s markets to U.S. investors. However, larger issues remain such as China’s reducing of subsidies to domestic firms as well as intellectual property theft. While the U.S. and China continue their trade negotiations, it was reported on January 14 that Chinese exports fell by 4.4% year-over-year, which marked the biggest decline since July of 2016.
Overall though, it wasn’t China that detracted the most to PMI last month, but rather the Euro area was the leading source of weakness to Global PMI, as output across the area weakened to its worst level since November 2014, according to J.P. Morgan. The yellow-vest protests in France, Italian budget negotiations, Brexit uncertainty, and a slowdown in German manufacturing have all dampened growth expectations in recent months. Germany’s economy is heavily focused on exports, and the slowdown in demand from China is already taking its toll on German industrial equipment as well as luxury automobiles. Germany’s GDP dropped by 0.2% in the third quarter, and it’s now widely speculated that the economy may have retracted in the 4th quarter as well, pushing the world’s fourth largest economy into a recession. Meanwhile in the U.K., Prime Minister Theresa May suffered a crushing defeat when her Brexit deal was rejected in a historically lopsided vote. She overcame a no-confidence vote, but the fate of the U.K. and Euro relations are still very much up in the air. As representatives of the European Union have made it clear that the terms of the Brexit deal are non-negotiable, it appears the U.K. is either heading for a “no-deal” Brexit, or a last-minute extension to the original March deadline. At this point no one knows how this will play out, but in the meantime will definitely create even more uncertainty in the region.
As discussed earlier, risky assets in general took it on the chin in December. After a rebound month in November, the Russell 3000 All-Cap U.S. index was down 9.35% for the month, resulting in year-end performance of -5.76% for 2018. The equity selloff gained momentum on December 19th, after the Fed raised rates for the 4th time in 2018, even though the move was widely anticipated. Other causes cited included poor investor sentiment, rising peak cycle concerns, hedge fund capitulation, and the destabilizing impact of U.S. trade policy. Small caps fared worse than large caps, though we’re already seeing a reversal of that trend in the early days of 2019. In the 4th Quarter, the Energy sector experienced the greatest losses, declining by 23.85, as crude oil fell by almost 36%. Other sectors that were hit the hardest included technology and industrials, which both fell by about 17.4%. In general, the more defensive sectors performed much better, as utilities climbed 1%, and consumer staples fell by just 5.2%, compared to -14.4% for the overall market in the quarter.
Fixed income on the other hand, finally enjoyed a strong month as investors shed riskier assets and flocked towards safety. The yield on the 10-year U.S. treasury fell from 3.01% to 2.68% in December as longer dated bonds and treasuries rallied. For the year, the U.S. Aggregate Bond Index basically ended flat, after turning out a strong 1.84% performance in December. Municipal bonds climbed last month as well and ended 2018 higher by 1.28%. Investors also turned towards gold as a safe haven trade, as the yellow metal climbed 4.73% in December, and 7.24% overall in the 4th quarter. The U.S. dollar was slightly higher in the quarter, as the broad-based U.S. dollar index climbed from about 95 to 96 over the quarter, although it was as high as 97.7 around the middle of December before the greenback gave back some gains.
Will 2019 spark the next equity rally, or will fundamentals deteriorate and lead us into the next recession? Arguments can certainly be made for both sides… The January rally could very well continue, as stock valuations look very attractive, especially given the recent selloff and concurrent earnings growth. According to a model kept by Yardeni Research Inc, the S&P 500 Forward P/E to Growth ratio reached 0.85, which was the lowest level reached since the great recession. In other words, stock valuations in relation to projected 5-year growth rates are looking very attractive from a historical standpoint. On the flip side we see mounting evidence of peaking earnings and slowing growth overseas, which coupled with decreased monetary accommodation could mean the end of this decade long business cycle. Based upon research by Capital Economics, the world is set for its slowest growth rate since the financial crisis. While the U.S. continues to perform well (for now), a number of significant reductions in Euro-area GDP forecasts could lead to global GDP growth falling from 3.7% in 2018, to 3.1% in 2019, and 2.8% in 2020. Because of such repressed growth projections, it is hard to envision a widespread surge of inflation which would require much further tightening of monetary policy. While inflation has slightly risen the past few years, it remains very low by historical standards and has yet to consistently breach the Fed’s 2% threshold. Keeping in mind that Core PCE was close to 0% just a few years ago, we now have core inflation of 1.9% (not including food & energy).
We remain cautious regarding the overall state of the global economy. The market may have gotten a bit ahead of itself when it sold off last month, but many of the causes such as rising rates, peaking earnings, and slowing demand remain intact and could become major factors heading into the next recession. While here in the U.S. we are still fully employed, and confidence remains high, the effects of a global slowdown will eventually make its impact here as well. Also, a concerning matter, the government shutdown continues to drag on with no immediate end in sight. Originally thought to have very little economic impact, now some economists are projecting it could shave as much as 0.25% off of 1st quarter GDP, if not worse. Jaime Dimon, CEO of J.P. Morgan, stated on January 15th that the record-long shutdown could even drive economic growth down to zero in Q1. At the very least, it seems to be a safe assumption that overall economic growth will decline in 2019. In a best-case scenario, growth will slow just enough to prevent the Fed from over-tightening, but not enough to push GDP into negative territory. However, if the trade spat with China continues or escalates, or if the economic conditions in Europe and China continues to deteriorate, we may be headed towards a recession in late 2019 or early 2020. Regardless of the timing, we believe there will be more volatility in the months ahead and given the rising uncertainties will continue to invest prudently and conservatively. Our risk mitigation strategy, which consists of value-oriented funds, low volatility ETFs, and other conservative funds, should help buffer against future volatility. We also continue to invest clients into structured notes with buffers for market participation with reduced market risk. Together these investments will help clients achieve optimal risk adjusted returns over the long run, as we enter what could be a very challenging environment in 2019.