Fourth Quarter 2018: Global News, Market Transitions and a Look Ahead

January 3, 2019

The year started on a very positive note, with January generating a return above 5% for both U.S. and foreign stocks. While a gain in January has historically translated into a gain for the entire year, that was not the case in 2018. As we have noted in some of our previous articles, this year has been a time of transition for the markets; low interest rates, low inflation and low volatility have persisted for some time, but stronger economic growth, rising deficits, tighter labor markets and more headline risks have caused investors to experience an increase in interest rates and market volatility. Additionally, while inflation has remained moderate, it has recently picked up somewhat, driven mainly by wage inflation in an environment where the unemployment rate is near a 50-year low.

To recap the year, the U.S. markets celebrated the tax cuts enacted in late 2017 and the deregulation of certain industries. The combination of these two factors caused small business owner optimism to soar to levels never seen before. Economic growth stayed strong throughout the year: 2.2% in the first quarter; 4.2% in the second quarter; 3.4% in the third quarter; and the estimate for the fourth quarter is between 2.5% and 3.0%. Depending on the final number for the fourth quarter, the full year economic growth rate could come in at or above 3.0%, which would be the highest economic growth rate since 2005. In terms of corporate earnings, growth has been strong all year, powered by lower corporate tax rates, consumer confidence and company stock buy-backs. With all of these positives, you might think this had been a banner year for the global markets, but unfortunately, this has not materialized.

The talk of tariffs began in the first quarter, when import taxes were added to washing machines and solar panels. These import taxes would be an indicator of things to come. Tariffs were then applied to steel and aluminum imports, and the Trump administration made it clear that all trade agreements were up for negotiation. While the North American Free Trade Agreement (NAFTA) was modified, the three countries affected agreed to changes that created the United States-Mexico-Canada Agreement (USMCA). With that agreement completed, the focus turned to China, with both the U.S. and China implementing import taxes on a significant amount of goods and services. It appears progress has been made, but global market participants continue to hold their breath, as the two largest economies in the world seem to be out of sync. This disharmony extends beyond global trade and includes intellectual property, technology transfer and potential currency manipulation.

Furthermore, the Federal Reserve stayed in focus for most of the year, as it raised short-term interest rates four times. These increases were expected by the markets. Over the last four years, short-term interest rates have moved from 0.25% to 2.50%. We view this action positively, as it is an indication of a return to normal economic conditions; however, Federal Reserve Chairman Jerome Powell has faced criticism by those who believe he is hurting economic growth.

In terms of market performance, the fourth quarter results were very disappointing for investors. U.S. large company stocks (S&P 500) declined by 13.5%, while the Russell Mid-Cap index lost 15.4%, and the Russell Small Cap index was the worst performer at -20.2%. International stocks in the developed markets of Europe and Japan, as measured by the MSCI EAFE index, were not immune from the downturn at -12.5%; and the MSCI Emerging Markets benchmark declined by 7.5%. Stable intermediate-term interest rates caused the bond market to produce a positive return of 1.6%, based on the Barclay’s Aggregate index.

As we turn the page to 2019, there are reasons for both optimism and caution. Improved market valuations and the expectation of continued economic growth and corporate profitability cause us to be optimistic. On the cautionary side, while some would list the Federal Reserve’s potential actions as the biggest risk factor, we believe that the trade relations between the U.S. and China will dictate whether 2019 is a successful year. We are prepared for more volatility and unpredictability, and we will be closely monitoring the markets, the economy and our portfolio allocations.