apital markets this year surprised us. Given strong corporate earnings and a favorable economic backdrop, we expected positive equity returns. Indeed the S&P 500 Index rose in a relatively orderly manner from the end of 2017 through the third quarter of 2018 by 9.6%. However, from September 20, when markets peaked through the end of the year, the Index fell 14.5%, resulting in a decline in 2018 of -6.2%. Including dividends, the total loss of the S&P 500 Index was -4.2%.
Given the gradual tightening of monetary policy by the Federal Reserve, interest rates rose in 2018. The target rate for Fed Funds was increased four times by a total of 100 basis points to the 2.25% – 2.50% range. The impact on long maturity bonds was not as large. The 10- and 30-Year Treasury Bonds increased only 28 and 20 basis points respectively. Because the yield curve flattened, the negative impact of higher interest rates on bond returns was reduced. The return on the Bloomberg Barclays US Aggregate Bond Index ended virtually unchanged for the year.
As disappointing as U.S. equity performance was in 2018, global markets did much worse. Most other asset classes performed poorly. See the following Table 1.
|Performance of Selected Markets in 2018|
|2018 Total Returns|
|U.S. Stock Markets|
|S&P 500 Index (SPX)||-4.20%||-4.20%|
|Foreign Stock Markets|
|Europe EURO STOXX 50 Index (SX5E)||-15.03%||-10.90%|
|UK FTSE 100 Index (UKX)||-13.58%||-8.50%|
|German Stock Index (DAX)||-22.20%||-18.30%|
|Japan Nikkei 225 (NKY)||-8.44%||-10.22%|
|China Shenzhen Composite Index (SZCOMP)||NA||-32.27%|
|India SENSEX index (SENSEX)||-2.00%||7.20%|
|MSCI Emerging Markets (Dollar Index)||-15.25%||NA|
|Dollar Versus Other Currencies|
|Bloomberg Dollar Spot Index (BBDXY)||3.69%|
|Bloomberg Commodity Index (BCOM)||-13.23%|
|WTI Crude Oil (per barrel)||-24.78%|
|LME Copper (3 Month Rolling Forward) (LMCADSO3)||-17.21%|
|Gold (per troy ounce) (XAU)||-2.65%||Source: Bloomberg|
Developed-country stock markets in Europe and Japan fell by much more than the United States. The returns on emerging market equities were especially disappointing. The MSCI Emerging Markets Index declined by more than 15%, reflecting the poor performance of Chinese stocks. By far the best performing emerging market was India’s SENSEX index.
The appreciation of the dollar versus the other major reserve currencies severely penalized foreign bond markets. Our foreign bonds are dollar denominated and investment grade. Commodities generally declined in 2018. The biggest surprise was the weakness in oil, pressured by surging production in the United States and lackluster global demand. The U.S. benchmark, West Texas Intermediate, dropped by nearly 25%.The Bloomberg Commodity Index fell by 13%. Even the price of gold was off 2.7% for the year.
On the whole, the strategy of emphasizing large-capitalization, multinational U.S. corporations has paid off.
Overview of the Investment Outlook
The sharp sell-off in global markets in the fourth quarter of 2018 indicates that investors are broadly concerned about the investment outlook. Our approach is to form a judgment on capital markets based on economic and corporate-profit growth prospects, and on valuations. U.S. markets seem out of sync with these indicators, which remain generally positive.
U.S. Economic Outlook
The U.S. economy benefitted significantly from the stimulus of the December 2017 Tax Cuts and Jobs Act (TCJA). The impact was felt beginning in Q2 when real GDP growth rose to 4.2% per annum. For the full year, the economy is expected to have advanced around 3%, which compares favorably to 2016 and 2017 growth rates of 1.6% and 2.2% respectively. Based on the consensus of 80 economists, Bloomberg projects that real U.S. growth by 2020 will dip back to 2% or less per annum, which is in line with the most recent Congressional Budget Office and Federal Reserve forecasts.1
It is disquieting to some investors that the Federal Reserve is tightening monetary policy when the economy is about to slow down. Traditional economics dictate that when the economy is near full employment, interest rates should be raised to prevent overheating and inflation on the one hand, and to recharge monetary policy on the other.2 The Fed Funds target rate was expected to be increased in 2019 in four steps by another percentage point to the 3.25% – 3.50% range. Based on the Economic Projections released by the Fed in December, there may be only three hikes in 2019. Chairman Powell is mindful that the Fed must artfully dance between raising interest rates and accommodating the economy’s requirements.3
One of the astonishing aspects of the U.S. economy at this time is that despite full employment, there has been little inflation. Consumer prices in 2018 (through November) rose around 2.2%, in line with the Fed’s target rate of 2%. Real average hourly earnings in this period increased 0.8%. Monetary authorities don’t feel a compelling need to raise interest rates to combat inflation. The flattening of the yield curve alluded to previously is an indication that bond investors believe economic activity is slowing, inflation is not a risk, and the Fed will not act aggressively.
Global Economic Outlook
The global outlook remains positive. The forecasts for the global economy have been moderately adjusted down throughout 2018 but still remain favorable, in the 3.5% – 4.0% range for 2018 and 2019.4
The Chinese economy has been a major engine of global economic growth. Based on a recent forecast by the IMF,5 real growth in GDP is projected to decline from an estimated 6.6% in 2018 to 5.5% in 2023. The risk of a hard landing relates to whether the government can successfully address over-investment in industrial capacity, the largely unoccupied phantom cities, inflated real estate prices, and excessive debt positions in the banking system and state financial institutions. The question is whether the Chinese Government can manage to navigate this daunting complexity.
The direct impact of lower economic growth in China on the United States is limited but does adversely affect U.S. companies with Chinese operations like Boeing, Caterpillar, General Motors, Apple, Intel, Qualcomm, and other tech companies.
The trade disputes between China and the United States are affecting investor sentiment. In 2017 the United States had a trade deficit with China amounting to $336 billion or about 1.7% of GDP.6 U.S. companies want to participate in what will soon be the largest consumer market without having its intellectual property stolen, unfair restrictions placed on direct investments, and other regulations imposed on operations in violation of the World Trade Organization Agreement. The tariffs thus far assessed on Chinese goods affect less than 10% of U.S. imports. Additional tariffs are scheduled to be imposed in 2019 but have been deferred pending further negotiations. We believe a trade war will be avoided and many U.S. grievances will be settled in 2019. The softening of the Chinese economy weakens its bargaining position, and the administration’s stance in its recent trade negotiations with the EU, Canada, and Mexico has been surprisingly undemanding.
Corporate profits in 2018 received a very substantial boost from the TCJA, which reduced the highest corporate tax bracket from 35% to 21%. Standard & Poor’s estimates that S&P 500 Index operating earnings advanced from $124.50 in 2017 to $157.00 in 2018, an increase of 26%. An estimated two-thirds of the gain is attributable to lower taxes. In 2019, earnings growth will normalize at 6% – 9% to the $165 – $170 range. The general outlook for earnings of our major corporations remains favorable.
Bear markets in the past were primarily attributable to three causes: (a) the advent of a recession; (b) systemic problems in financial institutions; and (c) bubbly valuations. We see little risk of a recession near term, even allowing that the consensus view of the global economy and economic outlook in the United States may be too optimistic. Our financial institutions have been significantly strengthened since the financial crisis of 2008 – 2009 owing to the Dodd–Frank legislation. There are no systemic problems of the type that crushed equity markets in that period. Excessive valuations were the primary cause of the sharp selloff in stock prices in 2000. As a result of the recent decline in equity markets, current valuations are reasonable. As shown in Table 2 below, the forward multiple on earnings has declined from 17.1x at the end of 2017 to 14.6x as of December 31, 2018.
|S&P 500 Index Levels, Earnings and Price/Earnings|
|Current Price Earnings Ratios||2017||2018||2019|
|S&P 500 Index||2,688||2,507|
|S&P 500 Earnings *||$124.51||$156.99|
|S&P 500 Price/Earnings||21.6||16.0|
|* Actual earnings in 2017 and estimated earnings in 2018|
|Forward Price Earnings Ratios|
|S&P 500 Index||2,688||2,507|
|S&P 500 Earnings **||$156.99||$171.74|
|S&P 500 Price/Earnings||17.1||14.6|
|** Estimated earnings in 2018 and 2019.||Source: Standard & Poor’s|
The major global risk is China. If the current downward trend in the economy accelerates or if China goes into a recession, the global economy would be in new territory and experience severe stress. While we believe a trade war with China will be avoided, it is a risk factor.
In the United States, the political situation could be a risk. In the post-World War II period, the United States acted in ways to promote international order and stability by cultivating broad alliances and promoting international institutions. The emphasis was on acting collaboratively. Our currency was sound, our economy strong, and the world generally prospered.
Under the Trump administration, the United States has embarked on a different path that emphasizes its own well-being. Treaties and agreements have been set aside: the Paris Climate Agreement, the Iranian Nuclear Agreement, and the Trans-Pacific Partnership, among others. It is not that these arrangements were good or could not have been improved, but rather that the abruptness and the apparent lack of a deliberate process underlying our decisions are unsettling and undermine confidence.
The administration’s actions are harming our relationships with traditional allies such as Canada, the United Kingdom, Germany, and France. It is difficult to understand the strategic advantages the administration is seeking. Near term, the disruption to the global economy is likely to be limited. Longer term we are less confident.
We are concerned with the ongoing investigations and litigation involving the president, which should come to a head in 2019. We do not know what the impact on markets will be from the possible paralysis of the president (a real possibility) or his impeachment (less likely).
In the past when we have acknowledged external political risks such as the nuclear threats of Iran and North Korea, we felt that such risks were overstated and could be addressed by the world community. Now the risks seem to lie with the predictability of our own government.
Despite the slowdown in the U.S. and global economy and the contentious political issues, our views on the investment outlook remain positive. The world is more complicated and less certain. But we agree with Chairman Powell, who stated that the latest economic data suggested “ongoing [economic] momentum heading into 2019. The markets are pricing in downside risks. They’re well ahead of the data.”7 While we believe that equities are the asset of choice, our future expectations have been tempered and we expect mid-single digit returns going forward. There is risk in bonds. Even if rates are not hiked as expected, the current low level of interest hardly provides real returns to investors.
Stratigraphic Asset Management, Inc.
- “Congressional Budget Office August 2018 Baseline Forecast.” “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents,” December 19, 2018.
- If interest rates are not raised from current low levels, then when the next recession arrives, the Fed will not be able to lower rates to stimulate economic activity. In any case, at full employment, low interest rates probably provide little incremental stimulus.
- On January 4, 2019, Chairman Powell stated “We are always prepared to shift the stance of policy and to shift it significantly if necessary” to meet the goals of maximum employment and stable prices. “Powell says he would reject any Trump request to resign,” Associated Press, New York Times, January 4, 2019.
- World Economic Outlook, International Monetary Fund, October 2018.
- People’s Republic of China, IMF Country Report, No 18/240, July 2018.
- The U.S. Bureau of Economic Analysis calculated that the total trade deficit in 2017 reduced GDP from about 2.5% to 2.2%. The excess of imports from China over our exports represents about 40% of the total trade deficit. https://www.bea.gov/news/2018/us-international-trade-goods-and-services-october-2018
- “Powell Says a ‘Patient’ Fed Is Watching for Signs of Economic Weakness,” New York Times, January 4, 2019.