The fourth quarter began on an upbeat note for U.S. equity markets as participants responded positively to a deal forged by the U.S. and Canada to salvage NAFTA as a trilateral pact with Mexico, rescuing a three-country, $1.2 trillion open-trade zone that had been about to collapse after nearly a quarter century. Volatility, however, quickly returned as investors worried about late cycle dynamics, seemingly focusing more on earnings growth sustainability than on generally strong third quarter corporate results. The recent tax cuts provided a boost to corporate earnings but investors, aware that its impact will begin to diminish in 2019, began to digest the prospect of a slowdown.
Large cap growth stocks that had led the market up earlier in 2018 (e.g., technology stocks like Amazon, Apple, Alphabet and Netflix) declined sharply in the fourth quarter especially in November and December, with the technology sector component of the Standard & Poor’s 500 Index down over 17%. Consequently, value stocks led growth stocks though both were down for the quarter. Additionally, as fear gripped the equity market in Q4, interest rates fell and bonds rallied, with Government bonds up about 2.5%.
Economic concerns weighed on international markets as global growth became less synchronized. A key theme for 2018 was the strength of U.S. markets relative to the rest of the world. For the year, the S&P 500 returned a negative 4.4% while the MSCI EAFE index dropped nearly 14%. With expected GDP growth of about 6.5%, the Chinese economy is growing at its slowest pace since 1990. And weakness in China certainly had an effect on other regions. Germany, Europe’s largest economy, experienced its first quarter-on-quarter economic contraction since the first quarter of 2015. Weakness was also displayed in Japan, where a series of natural disasters caused this country’s economic growth rate to also turn negative in Q3.
Fixed income markets generally produced positive results during the quarter as investors sought refuge from volatile equity markets. Government issues led the way with the Bloomberg Barclays U.S. Government Bond index up more than 2.5%. In contrast, credit markets lagged. The Bloomberg Barclays U.S. Credit index was flat for the quarter, while the Bloomberg Barclays U.S. Corporate High Yield Bond index fell 4.5%.
In the U.S., our outlook for 2019 is generally positive, reflecting a constructive view on economic growth, inflation, and earnings. Furthermore, greater clarity on trade and Federal Reserve monetary policy may well emerge. Risks to this outlook include the potential of aggressive action by the Fed, slowing global growth, and declining margins as corporate America absorbs rising wages and other input costs. Signs of slowing global growth and signals from the Fed will be key market drivers. Trade-related issues continue to be a risk because they have the potential to negatively impact global growth rates. In short, we think U.S. markets are late but not at the end of the cycle. We do not expect a recession in 2019, and think that the current market has potential for some upside.
In developed overseas markets, we expect Europe and Japan will be able to rebound from recent, temporary setbacks. In Japan, rising household incomes and strong business confidence are tailwinds. In Europe, credit is expanding and financial conditions remain supportive of growth, while issues in Italy and Brexit pose risks. Solid, single digit earnings growth is reasonable to expect in Europe. Recent market declines have pushed popular valuation measures to their cheapest levels in many years.
Valuations are compelling in emerging markets, but trade related issues, a slowing Chinese economy, and further U.S. dollar strength are concerns.
Fixed income investors should expect greater volatility as markets adjust to tightening financial conditions. Tighter global monetary policy, a strong U.S. dollar and slowing global growth are likely to limit the rise of bond yields going forward.
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Based on the S&P 500 trailing twelve month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading in the 30th percentile.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers a November 2018 reading in the 46th percentile.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
About the indices presented above:
- Standard & Poor's 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
- The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
- The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
- The MSCI ACWI (All Country World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world.
- The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada.
- The MSCI Emerging Markets Index (EM) captures large and mid cap representation across 24 Emerging Markets (EM) countries.
- The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
- The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
- The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
- The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. GW & Wade assumes no duty to update any of the information presented above.
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GW & Wade, LLC