Disappointing 2018 in spite of strong growth; markets disconnected from fundamentals.
Buoyed by big tax cuts and positive business sentiment, investors started out 2018 full of optimism that was later validated with upward corporate earnings revisions throughout the year. However, concerns over Fed overtightening kicked off a rough fourth quarter that culminated in indiscriminate selling by mid-December. From the S&P 500 Index’s closing high on September 20th to the bottom on Christmas Eve, the Index experienced a 19.8% drawdown, which made it a bear market for all intents and purposes. Overseas markets also sold off in December, though not to the same extent as expectations were already subdued. Pervasive bearishness over global growth outlook dragged down crude oil and base metal prices. Unsurprisingly, traditional safe havens such as the U.S. Treasury and precious metals rallied. However, as shown in the adjacent table, it was a poor return year across asset classes. Cash, which yielded about 2%, was the best performing major asset class.
In the fixed income market, rising risk aversion pushed up corporate bond spreads and drained liquidity – the U.S. high yield market had its first zero issuance month since November 2008, the midst of the Great Financial Crisis. The U.S. investment grade corporate bond issuance was only $7.95 billion, the slowest December since 1995.
In spite of the market dislocation, U.S. consumers remained resilient. Mastercard SpendingPulse reported the strongest U.S. holiday shopping season in six years. However, recent economic and sentiment surveys have shown weakening expectations as well as a loss of momentum. It is not a surprise that the U.S. economy is decelerating from 2018’s sugar high, and the current debate is over the magnitude of the slowdown. Bloomberg’s survey of 81 economists pegs the median 2019 GDP growth forecast at 2.6% with a range of 0.8% to 3.7%. Although, history has shown that economists have rarely forecasted recession with sufficient lead time. While we expect healthy U.S. growth in the first half of 2019, the second half will likely be more challenging. There is the risk that the market selloffs and political dysfunction could negatively affect business and consumer confidence to trigger a behavioural change for the worse. With Washington mired in gridlock, the burden is on the Fed and business leaders to do the heavy lifting.
Historically, it was unusual for the S&P 500 Index to suffer a 20% drawdown in the absence of an incoming recession, and in those rare instances, the S&P 500 Index had largely climbed back within months rather than years.
ACCIDENTS WILL HAPPEN
It happened on New York’s Fifth Avenue and 76th Street at around 10:30 pm on December 13, 1931. A British writer who was in the U.S. for a lecture tour got out of a cab on the southbound Central Park side and proceeded to cross Fifth Avenue against the traffic lights. Since traffic was kept to the left in the U.K., he merely looked to his left for headlights and did not realize that the north-bound lane was still in front of him (Fifth Avenue had two-way traffic then). As soon as he crossed the middle of the street, he was hit by a north-bound car moving at about 30 miles an hour. He was dragged several yards and flung into the ground, causing serious injuries. However, when police officers arrived at the scene, the victim honorably said, “I am entirely to blame; it’s all my fault.” The hapless driver, an unemployed mechanic, was thereby exonerated.
That British writer was, as the police and the media would later find out, Winston Churchill, then the U.K.’s ex-Chancellor of the Exchequer. He was rushed to Lenox Hill Hospital and diagnosed with a deep three-inch cut on the forehead, fractured nose, bruised shoulder, and two cracked ribs. While Churchill downplayed the extent of the injury to the public, it was a difficult recovery during which he was also inflicted with pleurisy and depression. However, the man with the lion’s heart eventually fought back. By February 14, 1932, he said he had “broken the back of the lecture tour without feeling any ill effects.” Churchill later made a remarkable political comeback, becoming the Prime Minister in 1940 and led the British Empire to triumph over Nazi Germany.
Interestingly, several months prior to that New York accident, something similar had happened in Munich. On August 22, John Scott-Ellis, a 17-year old English nobleman, was learning to drive in a red Fiat. Upon making a right turn into Brienner Straße, a pedestrian suddenly walked off the pavement and was hit by John’s car. The pedestrian, sporting a square mustache, fell to his knees but then managed to get up. When John and his driving instructor got out of the car to check on him, he shook their hands and assured them that he was not hurt. As the man walked away, John’s driving instructor told him that the man was a controversial rising political leader named Adolf Hitler. Imagine how the course of world history would be altered had one or both of those accidents resulted in fatality. There is an element of luck in everything.
IN DEFENSE OF THE FED
One has to go back to 1931, when Churchill was still recuperating at Lenox Hill Hospital to find a worse December than what the S&P 500 Index has just experienced. At the start of last month, we were hopeful that a more dovish Fed and progress on the Sino-U.S. trade negotiation would calm investors’ nerves and provide some holiday cheer. While there were positive developments on the trade front and the Fed indeed turned more dovish, investors appeared to have become impatient like President Trump in demanding an about-face from the Fed to suspend further rate hikes. When the Fed indicated that “some further gradual increases” were in the offing and that the pace of its balance sheet reduction was not to be altered, the stock market collapsed as if the economy would soon degenerate into recession. As fear evolved into the primary market driver, selling begot more selling and a downward market spiral became a self-fulfilling prophecy.
In an era of 24-7 news, tweetstorms, click-bait journalism, algorithmic trading, and instant search, there is no shortage of arm-chair experts pontificating on issues from monetary policy to market gyrations. Trump’s ascendancy has removed the mystique and nuance in policymaking by simplifying things to 280-character tweets and denigrating dissenters. Unpredictability is celebrated as the art of negotiation, and policies can flip-flop regardless of the real-life consequences. Together, these forces have created the narrative that a bear market was unavoidable because the Fed has over-tightened and Chairman Powell was tone deaf to the market’s warnings. In total disregard for the Fed’s independence, Trump even threatened to fire Chairman Powell.
Unlike knee-jerk traders and the President, the Fed can neither flip-flop on policy stance nor bend to the whims of markets or politicians. The Fed is an institution where issues are carefully deliberated and every word communicated to the public is closely scrutinized. As such, it was unrealistic to expect the Fed to abruptly pause its rate hiking campaign with the U.S. economy still growing above trend and the unemployment rate at a five decade low. Ironically, the Fed has become a victim of its own drive for transparency; the dot-plot introduced by ex-Chairman Bernanke may have reduced the current Fed’s communication flexibility. However, we believe Chairman Powell, having worked in the private sector, is attuned to signals from the real economy as well as financial markets. Indeed, the market has priced in a mere 10% probability of another rate hike, and we suspect the next policy change may be a cut.
YIELD CURVE INVERSION
The market’s “recession is nigh” narrative was keyed off the U.S. Treasury yield curve inversion indicator – probably the mostly widely-followed metric of late. The yield curve plots out the interest rates paid on Treasury bonds of various maturities. The yield curve is usually upward sloping as interest rates for longer dated bonds should be higher to compensate for the greater risk. Yield curve inversion occurs when the yields on longer maturity bonds fall below that of shorter maturity bonds. It happens when investors anticipate future economic weakness or deflation. Historically, yield curve inversion between the 2 and 10-year U.S. Treasury bonds has been a reliable signal of economic weakness. The 2/10 curve inversion would start the countdown to recession, which usually occurs 6 to 24 months later. The Fed, on the other hand, preferred to focus on the difference between the 3-month and 10-year Treasury yields.
On December 3rd, the 3/5 year yield curve inverted for the first time in more than 11 years. While the 3/5 year yield differential was not typically viewed as a recession indicator, it nevertheless raised the market’s anxiety and triggered renewed sell-offs. In our December 20th flash report, we noted that an inversion does not necessarily mean an imminent recession, as the time lag between the initial 2/10 year yield curve inversion and the start of the subsequent recession was 13 to 23 months during the last three cycles. Furthermore, the S&P 500 Index has moved higher by 8% to 32% after the last three 2/10 year yield curve inversions. At the end of 2018, the 2/10 and 3-month/10-year yield differentials were still in the positive territory — 19 and 31 bps, respectively.
We suspect markets have become quite jittery on any signs of recession because the current U.S. economic expansion has been getting long in the tooth. Most investors would concur with the notion that the current cycle is in the late innings. It has been nine and a half years since the end of the last recession. The longest post-WWII U.S. economic expansion was the 10-year cycle during the dot-com era of the 1990s.
While the current expansion is long in duration, it has been one of the weakest in magnitude. The real GDP at the end of the third quarter of 2018 was only 18% higher than the peak of the last cycle reached in the final quarter of 2007. Since WWII, there were four U.S. economic expansions that topped out at levels much higher than 18% above the prior cycle peak, and they ranged from 27% to 52%. The current cycle has also experienced a decline in private non-residential fixed investment, a hallmark of past recessions. This occurred during the first half of 2016, as capital expenditures in the energy industry were curtailed due to the collapse in crude oil prices. One can thereby argue that the current cycle, from the standpoint of capital expenditure, is only three years young. In short, the long duration of the current economic expansion does not necessarily mean that the end is near.
CAUTIOUSLY OPTIMISTIC BUT WITH EYES WIDE OPEN
In addition to the concern over Fed policies, we suspect two other developments have also contributed to the sell-offs – the lack of “adult supervision” at the White House, and further signs of weakening in China.
There was a string of high-profile departures from the Trump Administration in 2018 – Rex Tillerson, Gary Cohn, H.R. McMaster, and John Kelly – that culminated in the resignation of General Mattis, arguably the most respected Cabinet member. The president’s base may cheer the departure of the so-called globalists, but markets understand that “our strength as a nation is inextricably linked to the strength of our unique and comprehensive system of alliances and partnerships,” as eloquently stated in General Mattis’ resignation letter. The partial government shutdown over funding for the border wall should serve as a warning that the market-friendly aspects of the Trump presidency – tax cuts and deregulation – are now in the rear-view mirror, and what lies ahead may be two-years of political gridlock and populist accomodations.
The Chinese economy appeared to have taken a turn for the worse. In November 2018, China’s import from Hong Kong and auto sales dropped 5% and 14%, respectively. The country’s manufacturing Purchasing Managers’ Index (PMI) for December came in at 49.4, the first contraction since mid-2016. These numbers were hardly reflective of an economy supposedly growing at 6%-plus. China’s slowdown has impacts beyond its shores, especially on export-heavy economies such as Germany and South Korea. We view China’s slowing economy as one of the biggest risks to the market in 2019, and expect Chinese policymakers to roll out further stimulus to aggressively reflate the economy.
In spite of these risks, we believe global equities are poised for a rebound. Drowned out in the market carnage were several positive developments: lower oil prices should boost U.S. consumer’s discretionary spending power; China has just reduced tariffs on 700 items as a sign of good faith in the trade negotiation; and lower U.S. Treasury yields have led to a decline in mortgage rates. In a few months, there could also be green bamboo shoots in the Chinese economy. These trends likely portend continued U.S. and global growth, albeit at a slower pace. Historically, it was unusual for the S&P 500 Index to suffer a 20% drawdown in the absence of an incoming recession, and in those rare instances, the S&P 500 Index had largely climbed back within months rather than years. A prior instance took place in 2011, between the completion of the Fed’s second round of QE and the start of Operation Twist. It took five months after the market bottom for the S&P 500 Index to recover all the lost ground. Presently, the combination of a still healthy U.S. economy, more attractive valuations, and elevated fear makes us more sanguine about equities than we have been in quite a while. Of course, the market will need a little help from various institutions – the Fed should refrain from further rate hikes, China needs to move stimulus into higher gear, and Trump should act more presidential in a conventional sense.
In short, we are cautiously optimistic about 2019, but will be vigilant in assessing the risks and the potential blind spots in our assumptions.
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